WASHINGTON (Reuters) - The U.S. unemployment rate unexpectedly dropped to 7.8 percent in September and reached its lowest level since President Barack Obama took office, providing a boost to his re-election bid.

The Labor Department said on Friday that employers added 114,000 workers to their payrolls last month, a moderate number, but it said a combined 86,000 more jobs were created in the prior two months than it had previously thought.

Other aspects of the report also were strong. In particular, a separate survey of households found a big surge in hiring. That pushed the jobless rate down by 0.3 percentage point to its lowest level since January 2009.

“It’s a good report. The picture is still not a great one, but it’s not so bad given the unusual headwinds that we have been faced with,” said Ray Stone, an economist at Stone & McCarthy Research Associates in Princeton, New Jersey.

Obama said the report showed the economy was making progress while his Republican challenger Mitt Romney said the labor market was not healing fast enough.

Businesses have been hesitant to hire out of concern the U.S. recovery could take a hit from a sharp tightening of the federal budget next year, any worsening of the debt crisis in Europe and a slowdown in the global economy.

So far this year, job gains have averaged 146,000 per month, compared with 153,000 per month in 2011.

Economists had expected the unemployment rate to rise to 8.2 percent in September. The drop last month came even as Americans returned to the labor force to resume the hunt for work. The workforce had shrunk in the prior two months.

The household survey, which can be very volatile month-to-month, showed employment increased 873,000 -- the first rise in three months and the biggest since June 1983. But two-thirds of those were Americans who took a part time job even though they wanted full-time work, a fact that took a bit of the shine off the report.

Economists generally pay the most attention to the job growth figures from the much larger survey of employers. Over time, the surveys track each other, although many economists say the household survey sometimes takes the lead when trends shift.

Taken together, economists said the report broadly signaled a healthier labor market. The employment-to-population ratio, or the proportion of the working-age population with a job, increased to its highest level since May 2010.

Stocks on Wall Street initially rose, with the Dow Jones industrial average touching its highest point in almost five years, but they later retreated to close little changed as investors took profits. The dollar hit a two-week high against the yen, while U.S. Treasury debt prices fell.

U.S. interest rate futures also slipped as traders bet an improving jobs market could lead the Federal Reserve to back off its monetary stimulus earlier than had been expected.

A Reuters poll of top bond dealers, however, showed expectations holding firm that the Fed would end up buying $600 billion under a new stimulus program announced last month.

SPIN DOCTORS

There now remains only one more employment report before the November 6 election, and that comes just four days before voters go to the polls.

“We are moving forward,” Obama said as he plead his case during a campaign rally in a Washington suburb. “After losing about 800,000 jobs a month when I took office, our businesses have now added 5.2 million new jobs over the past 2-1/2 years.”

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“This country has come too far to turn back now.”

Despite the progress, the economy is still about 4.5 million jobs short of where it stood when the 2007-09 recession started and Romney sought to remind voters that the labor market was still far from healthy.

“There were fewer new jobs created this month than last month and the unemployment rate, you know, this year has come down very, very slowly,” Romney told a large crowd of supporters in Abingdon, Virginia. “The reason it has come down this year is primarily due to the fact that more and more people have just stopped looking for work.”

A Reuters/Ipsos poll released on Friday showed Romney narrowing the gap with Obama to only two points since Wednesday’s presidential debate, but analysts said Obama was due to get a lift from the jobs numbers.

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“Good economic news is good political news. President Obama needed that after the debate and it gives him numerical evidence that his policies are working,” said Julian Zelizer of Princeton University.

The surprise drop in the jobless rate led former General Electric CEO Jack Welch to suggest in a tweet that the numbers had somehow been doctored. “These Chicago guys will do anything,” he said in a reference to Obama’s campaign operation. Welch is a Reuters columnist.

Alan Krueger, a top economic adviser to Obama, said it was irresponsible to question the credibility of the numbers. “That’s a ludicrous comment. No serious person believes that the Bureau of Labor Statistics manipulates its statistics,” he told Reuters Insider television.

Economists and the BLS also dismissed the conspiracy theory.

FED LIKELY TO KEEP FOOT ON THE GAS

Persistently poor labor market conditions led the Fed in September to announce a plan to buy $40 billion worth of mortgage-backed securities each month until it sees a sustained turnaround in employment.

Despite the brighter signs on the jobs market, analysts said the central bank is unlikely to back off its stimulus anytime soon. After its last meeting, it said it planned to keep policy easy for “a considerable time” even after the recovery strengthened.

“This will be welcome news for the Fed, but given that the unemployment rate remains well above levels deemed consistent with full employment, their policy stance is unlikely to change,” said Millan Mulraine, a senior economist at TD Securities in New York.

The Fed’s ultra-easy stance has started to free up credit. A report from the Fed showed consumer credit rebounded strongly in August after posting its first decline in nearly a year in July.

Easier credit is supporting retail sales and home construction. Retail employment rose by 9,400, while construction added 5,000 jobs.

There we also gains in transportation and warehousing jobs, which increased 17,100. Financial services employment increased 13,000, and education and health payrolls surged 49,000.

Government payrolls rose 10,000 after increasing 45,000 in August. The gains last month largely reflected state and local government teaching jobs.

However, temporary help jobs, which are often seen as a harbinger of permanent hiring, fell 2,000, and manufacturing payrolls dropped 16,000, a second straight monthly decline. Job losses in the computer and electronics and the transportation sectors led the manufacturing decline.

Average hourly earnings rose 7 cents last month, the largest increase since June, which could support consumer spending, and the length of the average work week also increased slightly, another sign of strength.