WASHINGTON, Aug 3 (Reuters) - The U.S. unemployment rate rose to 4.6 percent in July as employers added jobs at the slowest rate in five months and the government actually reduced its workforce, the Labor Department said on Friday.

In another sign of slowing growth, the Institute for Supply Management reported the service sector grew more slowly in July as its index fell to 55.8 from 60.7 in June.

There were indications that problems in the housing sector, where lenders face rising mortgage defaults and prices are declining in many metro markets, appeared to be spreading into hiring as construction businesses cut 12,000 jobs last month.

Overall, employers added 92,000 jobs last month and estimates for job creation in each of the two prior months were revised lower, to 126,000 in June from a previously reported 132,000 and to 188,000 in May instead of 190,000.

The softer economic data played into worries among investors that subprime lending problems were worsening and helped drive stock prices sharply lower. A Bear Stearns senior official, Chief Financial Officer Sam Molinaro, warned credit markets were in their worst condition in two decades.

The Dow Jones Industrial Average plunged 281.42 points to end at 13,181.91 while the Nasdaq Composite Index

fell 64.73 points to close at 2,511.25.

Investors sought to reduce their exposure to risk by buying U.S. Treasury securities, driving prices for benchmark 10-year notes up 20/32 to yield 4.69 percent. Prices for 30-year bonds rose 23/32 to yield 4.87 percent.

July's new-job total was the smallest for any month since February, when 90,000 were added. But the surprising cut in government jobs -- the first in 1-1/2 years -- accounted for much of the decline. Private-sector hiring was ahead of June at 120,000 compared with 107,000.

STAYING VIGILANT

"I don't really see this as so much a sign of weakness, but more as a sign that companies are being really vigilant on cost controls and that it means we'll keep chugging along," said Lincoln Anderson, chief investment officer with LPL Financial Services in Boston.

Bush administration officials insisted the jobs numbers were proof of the economy's resilience in the face of costlier energy and showed economic expansion still had room to run.

"I think the jobs numbers, although lower than the previous month, are still within range and we still think of these as good, solid numbers," Council of Economic Advisers Chairman Edward Lazear told reporters at the White House.

The 4.6 percent unemployment rate in July was the highest since a matching 4.6 percent in January. The last time the rate was higher was in August last year, when it reached 4.7 percent, department officials said.

HOUSING FALLOUT

Some 12,000 construction jobs were shed in July, but Commerce Secretary Carlos Gutierrez said in a telephone interview that he considered problems in the housing sector were being unwound in an orderly way.

"I believe what we will be seeing is a continuing adjustment that we can manage through," Gutierrez said. "Other sectors can pick up the slack. We have managed through hurricanes, 9/11 (the Sept. 11, 2001, attacks) and stock market downturns, so we'll manage through this."

The lower July job-creation number could be reassuring for policy-setting members of the U.S. central bank's Federal Open Market Committee, which meets on Tuesday. Some have expressed worry that labor markets were growing so tight that it might fan inflation.

The Fed is widely expected to keep its trend-setting federal funds rate at 5.25 percent, where it has been for more than a year.

"The economy continues to move forward, but there are growing indications that the pace has throttled back," said economist Joel Naroff Naroff Economic Advisors Inc. in Holland, Pennsylvania, adding that he expects a further easing in growth.

All the July job growth came in service industries, which added 104,000 jobs, while goods-producing industries cut 12,000 positions.

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