By Lucia Mutikani

WASHINGTON (Reuters) - U.S. retail sales unexpectedly rose in May as consumers stepped up purchases of motor vehicles and building materials, which could help to stave off a dreaded recession in the near term.

While other data on Thursday showed first-time applications for state unemployment benefits holding steady last week at more than a 1-1/2-year high, indicating layoffs could be rising, economists continued to view the labor market as tight.

Minnesota recently changed policy to make non-instructional educational staff eligible for unemployment benefits during the summer break, boosting claims in the state.

Most economists have been forecasting a recession since late 2022.

The economy has remained defiant despite 500 basis points worth of interest rate increases from the Federal Reserve since March 2022, when the U.S. central bank embarked on its fastest monetary policy tightening cycle since the 1980s.

The Fed on Wednesday left its policy rate unchanged, but signaled in new projections that borrowing costs may still need to rise by as much as half of a percentage point by year end.

"The U.S. economy is holding up relatively well through the second quarter despite some softness," said Robert Kavcic, a senior economist at BMO Capital Markets in Toronto.

Retail sales increased 0.3% last month after rising 0.4% in April, the Commerce Department said. Economists polled by Reuters had forecast sales would slip 0.1%. Sales increased 1.6% year-on-year in May.

Retail sales are mostly goods and are not adjusted for inflation. Food services and drinking places are the only services category in the retail sales report.

Though the higher cost of living is causing consumers to be more selective and sensitive to prices, spending has held up thanks to strong wage gains from the strong labor market. The erosion of consumers' purchasing power has also slowed as inflation subsides. Some households still have savings accumulated during the COVID-19 pandemic.

"We should stop counting out consumers' spending desire and potential," said Mike Graziano, senior consumer products analyst at RSM US.

Sales at auto dealers increased 1.4%. Receipts at building material and garden equipment supplies dealers jumped 2.2%, likely driven by home renovations. There were also gains in sales at furniture stores as well as electronics and appliance outlets. Consumers spent more on hobbies.

Online retail sales gained 0.3%. Sales at food services and drinking places rose 0.4%. Economists view dining out as a key indicator of household finances. But cheaper gasoline depressed receipts at service stations.

Persistently strong demand could push the Fed to raise interest rates next month, though much would depend on June's employment and inflation reports.

"Higher interest rates haven't tamped down consumer demand enough to meaningfully slow price growth, especially on the services side of the economy," said Ben Ayers, senior economist at Nationwide in Columbus, Ohio. "These hot trends for consumers could led to another interest rate hike by the Fed in July."

There was, however, some good news on inflation. Import prices fell in May and the annual decrease in prices was the sharpest in three years, a separate report from the Labor Department showed on Thursday.

Stocks on Wall Street gained, with the S&P 500 and Nasdaq indexes hitting 14-month highs. The dollar fell against a basket of currencies. U.S. Treasury prices rose.

SLOWER MOMENTUM

Excluding automobiles, gasoline, building materials and food services, retail sales gained 0.2% last month. Data for April was revised slightly lower to show these so-called core retail sales rising 0.6% instead of the previously reported 0.7%.

Core retail sales correspond most closely with the consumer spending component of gross domestic product. With price pressures easing in May, economists estimated that core retail sales increased 0.2% after adjusting for inflation.

Consumer spending, which accounts for more than two-thirds of U.S. economic activity, grew at its fastest pace in nearly two years in the first quarter, offsetting the drag on GDP growth from a sharp inventory slowdown. The economy grew at a 1.3% annualized rate last quarter. The Atlanta Fed is currently estimating GDP will rise at a 1.8% pace in the second quarter.

A third report from the Labor Department showed initial claims for state unemployment benefits were unchanged at a seasonally adjusted 262,0000 for the week ended June 10, remaining at levels last seen in October 2021. Economists had forecast 249,000 claims for the latest week.

Unadjusted claims increased 28,763 to 249,212 last week. Claims in Minnesota rose by 3,664, while filings in Texas jumped by 7,123. There were also notable increases in California, which some economists tied to the fallout from an on ongoing strike by members of the Writers Guild of America.

Georgia, Florida, Illinois, Indiana, Connecticut and New York also reported significant rises.

"The rise in unemployment claims in the last two weeks, if sustained, would point to a rise in layoffs and a slowing in job growth but, at this point, fall short of signaling a yellow alert on the expansion of jobs," said Conrad DeQuadros, senior economic advisor at Brean Capital in New York.

The number of people receiving benefits after an initial week of aid, a proxy for hiring, increased 20,000 to 1.775 million during the week ending June 3, a still low level by historical standards, the claims report showed.

A fourth report from the Fed showed manufacturing output edged up 0.1% in May after surging 0.9% in April.

Manufacturing, which accounts for 11.3% of the U.S. economy, is being hobbled by higher borrowing costs as well as a shift in spending from goods to services.

But surveys of goods producers from the Federal Reserve banks of Philadelphia and New York on Thursday both showed the six-month business outlook at 15-month highs in June.

"There are most definitely cross-currents in today's manufacturing sector," said Tim Quinlan, a senior economist at Wells Fargo in Charlotte, North Carolina.

(Reporting by Lucia Mutikani; Additional reporting by Dan Burns; Editing by Chizu Nomiyama, Paul Simao, Andrea Ricci and Nick Zieminski)