WASHINGTON, Aug 7 (Reuters) - The U.S. economy unexpectedly shed jobs in July and nonfarm payrolls for the prior month were revised sharply lower, potentially raising questions about whether the Federal Reserve will increase interest rates next month.

Nonfarm payrolls decreased by 23,000 jobs last month after a downwardly revised 20,000 increase in June, the Labor Department's Bureau of Labor Statistics said in its closely watched employment report on Friday. Economists polled by Reuters had forecast payrolls rising 80,000 after advancing by a previously reported 57,000 in June. Estimates ranged from as low as 10,000 to as high as 140,000 jobs added.

Payrolls, however, have a tendency to be softer in July. Economists have viewed the labor market as being in a "slow hire, slow fire" mode. The economy appeared to have weathered the Middle East conflict, now in its sixth month, with domestic demand growing at its fastest pace in more than three years in the second quarter.

The unemployment rate fell to 4.1% from 4.2% in June as the labor force participation rate declined further.

Prior to the report, financial markets anticipated a September interest rate hike from the Fed. The U.S. central bank last week left its benchmark overnight interest rate in the 3.50%-3.75% range. Three members of the Fed's policy-setting committee dissented, preferring a quarter-percentage-point hike.

Next week's inflation data could sharpen the debate on the near-term monetary policy outlook.