* U.S. employers cut a surprise 263,000 jobs in September
* Unemployment rate climbs to 9.8 pct, a 26-year high
* Average work week slips, hourly earnings inch up (Adds Obama comments paragraph 12, Fed survey paragraph 21)
By Lucia Mutikani
WASHINGTON, Oct 2 (Reuters) - U.S. employers unexpectedly cut more jobs in September than in August, underscoring the fragility of the economy's recovery from its worst recession in 70 years as businesses remain cautious about the future.
The Labor Department said on Friday non-farm payrolls dropped by 263,000, marking the 21st straight monthly decline and helping to lift the unemployment rate to a 26-year high of 9.8 percent from 9.7 percent in August.
While the contraction in employment was worse than the 180,000 drop economists surveyed by Reuters had predicted, many believed it did not signal the start of a reversal in the trend toward stabilization of the labor market.
Economists said September's reading was distorted by a 53,000 drop in government employment, likely reflecting cutbacks by state and local governments, many of which are facing deep budget problems caused by the recession.
"We are more inclined to view September as a temporary setback than as a signal that the decelerating trend in job losses has stalled out," said Stephen Stanley, chief economist at RBS in Greenwich, Connecticut.
U.S. stocks ended lower as investors viewed the jobs data as more evidence of a slower recovery from recession. [.N].
Despite the signs of economic weakness in the jobs report, U.S. Treasury debt prices fell, pulling up the yield on the 30-year bond from five-month lows as investors took profits before next week's $78 billion in debt auctions. [US/].
BAD NEWS FOR OBAMA?
The jobless numbers might be bad news for U.S. President Barack Obama's attempt to reform the U.S. healthcare system, as Congress will want to limit spending on a health sector overhaul if the economy is taking longer to recover.
While Obama's overall approval ratings have stabilized at 50 percent or above since August, deepening unemployment could drag them down, and polls continue to show significant opposition to his handling of healthcare.
The government has put in place a $787 billion stimulus package to help the economy and the administration has hinted a second package might not be needed for now.
"Today's job report is a sobering reminder that progress comes in fits and starts -- and that we're going to need to grind out this recovery step by step," Obama told reporters.
The government revised job losses for July and August to show 13,000 more jobs were lost than previously reported.
A turnaround in the jobs market is viewed as the missing link in recovery from the longest and deepest slump since the Great Depression of the 1930s. The economy is believed to have started growing in the third quarter.
Since the start of the recession, the number of unemployed people has soared 7.6 million to 15.1 million, the department said. While the pace of job losses has moderated from early this year, companies are still not hiring on a big scale.
STILL ON TRACK FOR RECOVERY
"I don't think it argues against a modest recovery in the U.S. economy ... but this is why we are not in a rapid V-shaped recovery," Stuart Hoffman, chief economist at PNC Financial Services in Pittsburgh.
Among the main culprits behind the big drop in non-farm payrolls in September was the service-providing sector, which shed 147,000 jobs. Retail employment fell 38,500.
A gauge of labor market slack that measures both the officially unemployed and discouraged job seekers rose to a record 17 percent in September from 16.8 percent in August. The report also showed 5.4 million people had been unemployed for more than six months.
Some analysts reckon the unemployment rate would have breached the 10 percent mark last month were it not for the fact that the labor force fell by 571,000, a sign that some discouraged job seekers had given up the search for work.
The labor market slack and the anemic rise in wages suggest that inflation remains a distant threat for now and the Federal Reserve will probably delay withdrawing some of the support it is giving the economy.
A Reuters survey on Friday showed firms that deal directly with the U.S. central bank believe the Fed will not raise its benchmark overnight lending rate, currently near zero, until after the jobless rate has peaked. The jobless rate is seen peaking either late this year or early 2010. [ID:nN02610674]
Still, there were a few encouraging spots in the report. Manufacturing unemployment slowed and the number of newly unemployed people in the country eased to 2.97 million, the smallest in a year.
"It's yet another sign that the pace of layoffs has been slowing," said Bernard Baumohl, chief global economist at the Economic Outlook Group, Princeton, New Jersey.
The average workweek, which closely correlates with overall output and gives clues on when firms will start hiring, dipped to 33 hours from 33.1 in August. Average hourly earnings inched up to $18.67 from $18.66.
For graphics on the jobless rate and payrolls, see http://graphics.thomsonreuters.com/109/US_UNEMPL1009.gif (Additional reporting by David Alexander and Ross Colvin; Editing by Chizu Nomiyama)