By Lucia Mutikani

WASHINGTON (Reuters) - The U.S. economy created the fewest number of jobs in more than 5-1/2-years in May as manufacturing and construction employment fell sharply, which could make it harder for the Federal Reserve to raise interest rates.

Nonfarm payrolls increased by only 38,000 jobs last month, the smallest gain since September 2010, the Labor Department said on Friday. Employment gains were also restrained by a month-long strike by Verizon workers, which depressed information sector payrolls by 34,000 jobs.

Underscoring the report's weakness, employers hired 59,000 fewer workers in March and April than previously reported. While the unemployment rate fell three-tenths of a percentage point to 4.7 percent in May, the lowest level since November 2007, that was because 458,000 Americans gave up the search for work.

"This is not a good report, and it may well give Fed officials second thoughts about increasing interest rates again this month or next, as some have suggested lately," said Peter Ireland, an economics professor at Boston College.

The Fed has signaled its intention to raise rates soon if job gains continue and economic data remain consistent with a pickup in growth in the second quarter.

Fed Chair Yellen said last week that a rate increase would probably be appropriate in the "coming months," if those conditions were met. The U.S. central bank hiked its benchmark overnight interest rate in December for the first time in nearly a decade.

The dollar <.DXY> tumbled against a basket of currencies on Friday and was on track for its largest one-day percentage loss in four months. U.S. stocks also fell, while prices for U.S. Treasuries rose.

Financial markets largely priced out a rate increase at the Fed's June 14-15 policy meeting after Friday's data, according to CME Group's FedWatch program. The chance of an increase in July fell to 37 percent from about 59 percent late on Thursday.

Economists had forecast payrolls rising by 164,000 in May and the unemployment rate falling to 4.9 percent.

The weak report bucks data on consumer spending, industrial production and housing that have indicated the economy was gaining momentum after growth slowed to a 0.8 percent annualized rate in the first quarter.

In separate reports on Friday, the Commerce Department said goods exports rebounded strongly in April and orders for manufactured goods recorded their biggest gain in six months.

A survey by the Institute for Supply Management, however, showed a significant cooling in services sector activity in May.

DELAYED RESPONSE

Some economists said the sharp slowdown in employment last month was payback after unseasonably warm weather boosted hiring in February and March. They also viewed the weak payroll growth as a delayed response to tepid economic growth in the previous two quarters.

"The simplest explanation is that job growth tends to respond with a lag to GDP growth, and GDP growth was rather weak around the turn of the year. This would suggest job growth should recover along with overall growth in economic activity," said Michael Feroli, an economist at JPMorgan in New York.

Despite the poor performance in May, job creation has averaged 150,000 a month this year. That is well above the 100,000 monthly employment increase that Yellen has said is needed to keep up with growth in the work-age population.

Last month, the goods producing sector, which includes mining, manufacturing and construction, shed 36,000 jobs, the most since February 2010. Even excluding the Verizon strike, payrolls would have only increased by just over 70,000.

The Verizon workers, who were considered unemployed because they did not receive a salary during the payrolls survey week, returned to their jobs on Wednesday. They are expected to boost June employment.

Other details of the employment report were not encouraging. Average hourly earnings rose five cents, or 0.2 percent. That was a slide from April's 0.4 percent increase and left the year-on-year rise at 2.5 percent.

A broad measure of unemployment that includes people who want to work but have given up searching and those working part-time because they cannot find full-time employment held steady at 9.7 percent.

The labor force participation rate, or the share of working-age Americans who are employed or at least looking for a job, fell 0.2 percentage point to 62.6 percent. That drop unwound about two-thirds of the rise seen between last September and March of this year.

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