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

While the Labor Department's closely watched employment report on Friday showed the unemployment rate falling to 4.1% last month from 4.2% in June, that was because another 264,000 people left the labor force, pushing the participation rate to a near 5-1/2-year low of 61.4%. 

Job growth has a tendency to slow during summer, but last month's decline in payrolls and sharp downward revisions to May and June data could challenge the narrative of a "slow hire, slow fire" labor market.

"The labor market appears to have slammed the brakes on new hiring," said Christopher Rupkey, chief U.S. economist at FWDBONDS. "It isn't lights out yet for the economic outlook, but the future is dim if pessimism leads to more dropouts and companies cannot get the help they need to produce the goods and services the economy needs to grow."

Nonfarm payrolls decreased by 23,000 jobs last month, the Labor Department's Bureau of Labor Statistics said. 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.

The economy added 103,000 fewer jobs in May and June than previously estimated. Last year's big downgrades to the two months led to President Donald Trump's firing of the BLS commissioner, Erika McEntarfer. Trump, without offering evidence, accused McEntarfer of manipulating the data.

Financial markets priced in a 43.9% chance of the U.S. central bank hiking rates in September, compared with 57% before the jobs report, according to LSEG data. The Fed 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. U.S. Treasury yields fell after the data, while the dollar slipped against a basket of currencies.

Payrolls last month were weighed down by a 50,000 decline in local government education employment. The retail trade sector lost 19,000 jobs, the bulk of them at warehouse clubs, supercenters and other general merchandise stores. Employment in financial activities fell further, shedding 14,000 jobs. Financial activities jobs are down by 121,000 since peaking in May 2025. 

Healthcare payrolls increased 22,000, but well below the monthly average of 36,000 over the past year. Employment was little changed in the construction and manufacturing sectors. 

"Today's weak payrolls print may ease the pressure on the Fed to raise rates at its September meeting, but next week's inflation data will still likely be the deciding factor," said Ellen Zentner, chief economic strategist at Morgan Stanley Wealth Management. "If those numbers come in hotter than expected, a cooler labor market may not be enough to quiet the calls for hikes inside the Fed, or lower expectations outside of it."