WASHINGTON (Reuters) - Employers slowed their pace of hiring in July but the jobless rate fell anyway, a pair of mixed signals that could make the Federal Reserve more cautious about drawing down its huge economic stimulus program.
The number of jobs outside the farming sector increased by 162,000 last month, the smallest gain in four months and below analysts' expectations, Labor Department data showed on Friday.
The lackluster reading reinforced the view that the job market is only inching toward recovery from the 2007-09 recession and weighed on financial markets.
"We're sort of grinding along here," said Gordon Charlop, managing director at Rosenblatt Securities in New York.
At the same time, gains in employment were enough to push the jobless rate down to 7.4 percent, its lowest level since December 2008.
However, the report was full of details that cast the declining jobless rate in a poor light and raised doubts over whether the economy has improved enough for the Fed to begin reducing bond purchases at its next meeting in September.
Several Wall Street banks, in fact, pushed their forecasts for the Fed's so-called tapering move toward year end from September.
Part of the drop in unemployment was due to a decline in the size of the U.S. workforce, which only includes people who have jobs or are looking for work. The workforce can shrink when more workers retire or go to school, but it also contracts when people give up the job hunt.
Also robbing some of the report's luster, Americans on average worked shorter work weeks in July, while hourly wages fell. That bodes poorly for future consumer spending, the engine of the U.S. economy. The construction industry shed 6,000 jobs.
The government also said 26,000 fewer jobs were created in May and June than previously estimated.
The darker side of the report gave direction to Wall Street.
Yields on U.S. government debt fell sharply, suggesting investors were less confident the Fed could soon begin easing its bond purchases, which are aimed at spurring employment. U.S. stocks were mostly flat.
The U.S. central bank currently buys $85 billion a month in bonds to keep borrowing costs low, and the stimulus program has helped the country's beleaguered housing market and boosted car sales.
Fewer U.S. primary dealers now expect the Fed to start scaling back purchases in September than they did a month ago, according to a poll conducted by Reuters after the payrolls figures were released on Friday.
Nine of 18 primary dealers - the large banks that do business directly with the Fed - expect it to reduce its bond buying in September, while two predicted a cut back in October, five said December, one said the fourth quarter of 2013, and one said the first quarter of 2014.
In a similar poll conducted July 5, 11 of 17 dealers expected purchases to slow in September, three said October, only two said December, and one said the first quarter of 2014.
"After today I am solidly in December rather than September," said Michael Moran, chief economist at Daiwa Securities America in New York.
"Today's data do not necessarily lower the probability of a taper in September, but they don't cement the likelihood of a taper the way a stronger payrolls figure would have," said Dana Saporta, U.S. economist at Credit Suisse in New York.
Fed Chairman Ben Bernanke said last month the U.S. central bank would likely reduce its monthly purchases by the end of the year if the economy progressed as much as policymakers expect.
On Friday, St. Louis Fed President James Bullard said he believed the Fed should be careful about basing its decisions on forecasts and that policymakers should wait to see more data before deciding to taper bond purchases.
Other data on Friday showed a slight gathering of inflationary pressure, with the 12-month reading of the Commerce Department's gauge of core inflation rising to 1.2 percent in June from 1.1 percent a month earlier.
That could allay some concerns at the Fed that extremely low inflation could hurt the economy by giving consumers more reason to put off purchases.
Policymakers also might take comfort in a pace of hiring that at least appears to be steady. The jobless rate has fallen eight tenths of a percentage point in the last year.
"While July itself was a bit disappointing, the Fed will be looking at the cumulative improvement," said Paul Ashworth, an economist at Capital Economics in Toronto. He reckoned the Fed was still on track to trim its stimulus efforts in September.
Beyond the report's implications for policy, a deeper question is whether the pace of job creation can be sustained, given weak economic growth.
Gross domestic product, a measure of the nation's economic output, grew at a mere 1.4 percent annual rate in the first half of the year, down from 2.5 percent in the same period of 2012.
Most economists expect GDP will accelerate in the second half of this year, which would make it more plausible for the current hiring trend to continue.
But the fact that the jobless rate has fallen steadily despite weak output might point to a frightening possibility: perhaps the U.S. economy's growth potential has fallen.
This would mean less output is needed to create jobs but that incomes would grow at a slower pace over the long run. The prospect of such a structural shift worries economists and investors.
Friday's report could fan those concerns. The average work week declined to 34.4 hours in July, while average hourly earnings slipped 0.1 percent.
"The labor market remains stuck in quicksand," said Todd Schoenberger, managing partner at LandColt Capital in New York.
The report also showed 5.7 percent of Americans who had jobs in July could not get enough hours to qualify as full-time workers, the same percentage as in June.
While the unemployment rate has fallen steadily over the last year, the share of part-time workers who want more hours has barely dropped.
Also, the number of long-term unemployed, while falling, remains historically high. Bernanke has warned this situation could deal lasting damage to the economy's growth potential.
That is because people out of work for extended periods might never work again. In July, 4.25 million Americans had been unemployed for at least six months.
Reporting by Jason Lange; Additional reporting by Lucia Mutikani in Washington, Alister Bull in Boston and Alison Griswold, Ryan Vlastelica and Chris Reese in New York; Editing by Andrea Ricci and Ken Wills