The steadily worsening recession sent initial claims for unemployment benefits to 675,000 in the week ended May 17, by far the highest level in history, the Labor Department reported yesterday.

Underscoring the fact that the recession also has reduced sharply the demand for credit and sent market interest rates tumbling, the Federal Reserve Board yesterday lowered its key lending rate a full percentage point to 12 percent.

The Fed's action, decided on a 4-to-1 vote, "was taken entirely in reflection of recent substantial declines in shortterm market interest rates to levels well below the existing (13 percent) discount rate," it said in a statement.

Meanwhile, this year's big drop in oil demand, a result of both the recession and much higher prices, helped lower the nation's merchandise trade deficit in April to $1.9 billion, the smallest in three years, the Commerce Department said.

Exports fell 0.4 percent last month, but imports dropped dramatically by 6.2 percent, narrowing the deficit from $3.2 billion in March. Imports of crude oil and petroleum products plummeted 18.2 percent from 233 million barrels in March to 190.5 million in April, the department said.

Separately, the Labor Department also reported that labor productivity in the non-farm business portion of the economy fell at a seasonally adjust annual rate of 1.4 percent in the first three months of this year. Preliminary estimates released last month showed only a 0.2 percent rate of decline.

Hourly compensation also rose faster than the first quarter than had been estimated, at a 10.2 percent annual rate instead of 9.7 percent. That increase, coupled with the larger drop in productivity, meant that unit labor costs -- which directly feed inflation -- jumped at an 11.8 percent annual rate.

Analysts said the big increase in inflation claims for unemployment benefits, on a seasonally adjusted basis, means that the unemployment rate for May will be substantially higher than April's 7 percent rate. Some forecasters expect the May rate to reach at least 7.4 percent.

Among the states reporting increased numbers of people receiving benefits were Michigan, up 23,100 to 318,000; Missouri, up 17,100 to 82,200; and Illinois, up 14,000 to 217,400. The increases in Michigan were largely a result of further layoffs in the automobile industry, which were also a factor in Missouri. The increase in Illinois was due to lower employment in trade, services and construction industries, the Labor Department said.

The Federal Reserve was at some pains to stress that its action in lowering the discount rate -- the interest rate it charges banks that borrow directly from the Fed -- was following the money markets rather than a signal the central bank is trying to push interest rates lower.

The Fed doesn't want to give any indication, which officials, said would be incorrect, that monetary policy is switching from fighting inflation to countering the recession.

Henry Wallich, a conservative economist who is the only remaining member of the seven-person board appointed by President Nixon, cast the lone vote against lowering the discount rate.

The Commerce Department said merchandise imports, calculated on a basis that includes the cost of insurance and transportation, fell from $21,69 billion in March to $20.34 billion in April. Exports declined from $18.53 billion to $18.47 billion.

If the value of exports and imports are calculated on the same vasis -- without insurance and freight -- the deficit would be more than $1 billion less. As of this year the Commerce Department is barred by law from reporting those statistics for another 48 hours.

During a recession, a nation's trade balance often improves because the demand for imports falls more rapidly than demand abroad for exports unless other countries' economics are declining rapidly, to. The United States had a merchandise trade surplus in 1975, its last, for exactly this reason.

In addition to fewer oil imports, the United States also cut the trade deficit by improving the balance for manufactured goods. Exports of manufactured goods fell by $57.4 million to $11.744 billion, but imports fell by $210.4 million to $10.510 billion.

Agricultural exports, however, dropped by about $150 million more in April than did imports. Nevertheless, the United States still had a $1.933 billion surplus in agricultural trade last month, the department said.