By Jason Lange

WASHINGTON, Aug 2 (Reuters) - U.S. employers slowed their

pace of hiring in July but the jobless rate fell anyway, a pair

of mixed signals that could make the U.S. 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.

For one, 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.

TAPER TALK

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.

'Look for some soul searching by those who thought and acted

as if reducing (the Fed's) long-term asset purchases next month

was a done deal,' said Marc Chandler, a currency strategist at

Brown Brothers Harriman in New York.

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.

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 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.

STRUCTURAL CONCERNS

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 and Ryan Vlastelica in New York; Editing by Andrea

Ricci)

((jason.lange@thomsonreuters.com)(+1-202-310-5487)(Twitter

@langejason)(Reuters Messaging:

jason.lange.thomsonreuters.com@reuters.net))

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