Employment growth accelerated last month and the jobless rate dropped to a near three-year low of 8.5 percent, offering the strongest evidence yet the economic recovery was gaining steam.

Nonfarm payrolls increased 200,000 in December, the Labor Department said on Friday. It was the biggest rise in three months and beat economists' expectations for a 150,000 gain.

The unemployment rate dropped from a revised 8.7 percent in November to its lowest level since February 2009, a heartening sign for President Barack Obama whose re-election hopes could hinge on the state of the labor market.

The labor market is healing, but we still have a long way to go to recoup the losses we have endured. We may be close to a tipping point where gains can become more self-feeding, said Diane Swonk, chief economist at Mesirow Financial in Chicago.

A string of better-than-expected U.S. economic data in recent weeks has highlighted a contrast between the recovery in the world's biggest economy and Europe, which is already widely believed to be in recession and probably faces worse to come.

The stronger-than-expected jobs data was overshowed by persistent concerns over the euro zone debt crisis, sending U.S. stocks marginally lower. Prices for U.S. government debt rose, while a broad index of the dollar's value hit a one-year high.

Republican presidential hopefuls have blasted Obama's economic policies as doing more harm than good.

The latest economic signs, however, could offer the president some political protection. Over the course of 2011, the economy added 1.6 million jobs, the most in five years.

Still, employment remains about 6.1 million below its pre-recession level. At December's pace of job growth, it would take about 2-1/2 years to win those jobs back.

Unseasonably mild weather last month accounted for some of the boost to payrolls, fueling hefty gains in construction employment. Courier jobs also rose sharply, a gain the Labor Department pinned on strong online holiday shopping.

Employment growth could pull back in January and the jobless rate could rise as the improving conditions lure Americans who have given up the hunt for work back into the labor market.

FASTER JOB GROWTH PACE STILL NEEDED

The household survey, from which the jobless rate is derived, showed most of the drop in the jobless rate was due to gains in employment as the labor force shrank only modestly.

While economists generally regard the payrolls figures from the government's survey of employers as the most-reliable gauge of hiring, employment as measured by the household survey has now shown five straight months of solid gains.

A broad measure of unemployment, which includes people who want to work but have stopped looking and those working only part time but who want more work, also dropped to an almost three-year low of 15.2 percent from 15.6 percent in November.

All told, 23.7 million Americans are either out of work or underemployed.

With the labor market still far from healthy, the debt crisis in Europe unresolved and tensions over Iran threatening to drive up oil prices, the U.S. economy faces stiff headwinds.

Economists predict the recovery will lose a step early this year after expanding in the fourth quarter at what is expected to be the fastest pace in 1-1/2 years.

This should keep alive the possibility of the Federal Reserve embarking on a third round of asset purchases to spur stronger growth, even though prospects of a further easing of monetary policy were damped by the jobs data.

The Fed will be watching for further credible evidence that this improving trend is gaining traction because we also went through a better period in the first quarter of last year, said Anthony Karydakis, chief economist at Commerzbank in New York.

New York Federal Reserve Bank President William Dudley on Friday suggested the U.S. central bank was still leaning toward further policy easing, describing the recovery as frustratingly slow and the unemployment rate as unacceptably high.

Because the outlook for unemployment is unacceptably high relative to our dual mandate and the outlook for inflation is moderate, I believe it is also appropriate to continue to evaluate whether we could provide additional accommodation in a manner that produces more benefits than costs, he said.

GOVERNMENT A DRAG

All the job gains in December came from the private sector, where payrolls rose 212,000 - the most in three months. Government employment contracted 12,000.

For all of 2011, the private sector added 1.9 million jobs, while government employment fell 280,000. A measure of the share of industries that showed job gains during the month rebounded after falling sharply in November.

Construction payrolls increased 17,000 after falling 12,000 in November. Mild weather has boosted groundbreaking for new homes. Transportation and warehousing employment jumped 50,200.

The bulk of the rise came from the messenger industry, which added 42,000 jobs, probably reflecting an increase in deliveries of online purchases made during the holiday season.

Manufacturing jobs rose 23,000, the largest increase since July. Factory employment rose 225,000 last year. Retail employment rose 27,900, slowing after hefty gains in November as retailers geared up for a busy holiday shopping season.

But temporary hiring - seen as a harbinger of future hiring - fell 7,500 in December after gaining 11,200.

Even though employment picked up last month, hourly earnings rose a modest four cents, indicating that most of the jobs being created are low paying.

This is a potentially troubling sign for consumer spending, which has been largely supported by a reduction in savings.

Firms need to grow wages faster if consumption is to accelerate. There is not a lot of appetite to give raises, said Joel Naroff, chief economist at Naroff Economic Advisors in Holland, Pennsylvania.

(Editing by Andrea Ricci)

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