UPDATE 1-SF Fed economist- US recovery to be painfully slow

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By Ros Krasny

CHICAGO, July 14 (Reuters) - A "painfully gradual" U.S. recovery should start in the third quarter, even as the jobs market is still weakening, according to an economist with the San Francisco Federal Reserve Bank.

The recent vicious cycle, in which losses by banks led to tighter credit availability and then lower household and business spending, is slowing, economist Mary Daly said in the bank's latest "FedViews" newsletter.

Whether that improved trend continues, however, "depends in part on the labor markets, which continue to deteriorate," Daly said in the report, which was dated July 9 but posted on the bank's website on Tuesday.

The official jobless rate, plus those involuntarily working only part-time, account for more labor market slack than in the 1982 recession, and the measure will rise even higher by year end, she said.

The bank's economic team said real GDP should grow by about 1 percent in the third quarter, and continue to creep higher through the end of 2010.

Core personal consumption expenditures price inflation, meanwhile, could fall toward 1 percent during 2010, the team said. Core PCE rose by 1.8 percent in the year through May, the most recent figure available.

"Capacity utilization is at an all-time low. This excess capacity should continue to exert downward pressure on both input and final goods prices," Daly said. Wage and salary growth was also forecast to be depressed.

Long-term market expectations of inflation seem to be well-anchored, and current worries about large budget deficits fueling inflation seem misguided, she said.

"A look at the empirical link between fiscal deficits and inflation in the United States shows no correlation between the two," Daly said.

She forecast additional pressure on state and local budgets.

States' major sources of revenue -- income, sales and property taxes, have all been disrupted, and most started the 2010 fiscal year on July 1 with even larger budget gaps to solve.

"States will likely face constrained budgets for years to come," she said. (Editing by Dan Grebler)