* Initial jobless claims fall 21,000 last week
* Claims lowest in three months
* Continuing claims lowest in nearly two years
(Updates markets to close)
By Lucia Mutikani
WASHINGTON, Oct 28 (Reuters) - New claims for U.S. unemployment benefits unexpectedly fell to a three-month low last week but the underlying trend still points to labor market stagnation.
Initial claims for state unemployment aid dropped 21,000 to a seasonally adjusted 434,000, the Labor Department said.
Economists had forecast they would edge up to 453,000. The prior week's figure was revised up to 455,000 from 452,000.
Thursday's data, however, will likely carry little weight at the Federal Reserve's policy meeting on Tuesday and Wednesday, where further monetary stimulus for the sluggish economy is expected to be announced.
The weak economic recovery is a problem for congressional Democrats, who appear likely to lose their majority in the U.S. House of Representatives in elections next Tuesday. Their Senate majority is also seen at risk. For more see [USVOTE].
Some analysts said difficulties adjusting the data for seasonal factors may have skewed the numbers but others disagreed. The data followed the the Columbus Day holiday.
Claims tend to rise in the week after a public holiday but a department official noted that the rise in applications wasnot been as large as the model assumed when smoothing the data, leading to the decline in the adjusted number.
"My sense is today's number was organic, there weren't any weird quirks in it," said Neil Dutta, an economist at Bank of America Merrill Lynch in New York.
For a graphic on U.S. jobless claims see:
http://r.reuters.com/fud72q
FOUR WEEK AVERAGE FALLS
The four-week average of new jobless claims, considered a better measure of underlying labor market trends, fell 5,500 to 453,250, but remained in the range seen for much of this year.
"That's consistent with a labor market that is fundamentally stagnant. Anecdotally there is huge uncertainty hanging in the market right now, there really is no impetus for a leg up in job growth," said Dutta.
U.S. financial markets remained focused on the Fed's Nov. 2-3 meeting, with traders on Wall Street shying away from taking big bets. Stocks <.SPX> ended flat as traders also turned cautious ahead of Tuesday's midterm vote.
Prices for U.S. government debt
The U.S. economy's painfully slow recovery from the worst recession since the Great Depression has left the labor market subdued and the unemployment rate at 9.6 percent.
TARGET INTEREST RATES
The U.S. central bank cut overnight interest rates to near zero in December 2008 and has bought about $1.7 trillion worth of Treasury and mortgage-related debt since then in an effort to stimulate the sluggish economy by making money cheaper.
But it is concerned about the high level of unemployment and the low level of inflation, and analysts look for the Fed to launch a fresh round of bond purchases next week.
Some analysts believe it could also begin targeting interest rates to ward off the possibility of deflation -- a pernicious downward spiral in prices.
"The Fed is going to be more novel than most people believe," said Haag Sherman, chief investment officer at Salient Partners in Houston, Texas.
"They may actually target interest rates and leave the actual amount of bond purchases vague, which will allow them to save some of their ammunition. The market will recalibrate the (Treasury) yield curve based on their interest rate targeting."
The government is expected to report on Friday that the U.S. economy expanded at a 2.0 percent annualized rate in the third quarter, a touch faster than the second quarter's 1.7 percent but too sluggish to make a dent in the ranks of the jobless.
"We think the slow pace of hiring will not be sufficient to absorb growth in the labor force and that the unemployment rate will tick up to 9.7 percent," said Julia Coronado, an economist at BNP Paribas in New York.
In the week ended Oct. 16, the number of people still receiving benefits after an initial week of aid dropped 122,000 to 4.36 million, the lowest since November 2008.
The continuing claims data covered the period for the household survey from which the unemployment rate is derived.
The number of people on emergency benefits fell 258,102 to 3.78 million in the week to Oct. 9.