The unemployment rate surprisingly fell to a five-month low in January and factory payrolls grew for the first time since 2007, hinting at a labor market recovery even though the economy lost 20,000 jobs.

The White House cautiously welcomed the figures but said more needed to be done to put people to work. Democrats fear voters could punish them in November congressional elections if more headway is not made tackling unemployment.

The decline in payrolls reported by the Labor Department on Friday was less than the 150,000 drop in December. November's data from the survey of employers was revised to a gain of 64,000, up from 4,000.

The jobless rate, based on a separate household survey, fell to 9.7 percent from 10 percent in December. That survey found employment rising, with the size of the labor force roughly flat.

Analysts had expected payrolls to rise by 5,000 and the unemployment rate to edge up to 10.1 percent.

The wheels of the economy are turning. The improvement in the employment data does match the increase in GDP the last two quarters so it's not a fluke. The economic recovery looks much more sustainable today, said Chris Rupkey, senior financial economist at Bank of Tokyo/Mitsubishi UFJ in New York.

Details of the report were relatively upbeat. The length of the average workweek hit its highest level in a year and overtime in manufacturing was the most since September 2008, suggesting growing pressure to add to payrolls.

The drop in the jobless rate, which shocked economists, and the pickup in factory employment helped support a stock market weighed down by worries about European fiscal woes, but failed to keep shares in positive territory.

Government debt prices rose as traders opted to focus on the unexpected fall in payrolls, which convinced some that the Federal Reserve would be in no rush to raise interest rates.

Annual revisions to the payrolls data showed job losses since the recession began were much deeper than originally thought. The economy has lost 8.4 million jobs since the start of the recession in December 2007. Before the revisions, the figure was 7.2 million.

In January, the number of 'discouraged job seekers' stood at 1.1 million up from 734,000 a year ago.

JOB POLITICS

With Americans increasingly anxious about high unemployment, President Barack Obama has declared that job creation will be his top priority in 2010. Obama was set to announce later on Friday plans to expand credit for small businesses in the hope of spurring job growth.

We still have a hard recovery to work our way through here, Labor Secretary Hilda Solis told Reuters Insider. We're on the right path but we need more.

Financial markets have grown nervous about the prospect of unemployment in the United States remaining high for a long time. The economy resumed growth in the second half of 2009, but a labor market recovery has yet to materialize.

While the U.S. economy is growing, recovery hopes in Germany were dealt a set back by a sharp drop in industrial output in December.

Analysts expect payrolls to start growing in February as the government steps up temporary hiring for the 2010 Census.

This hiring will continue to push the unemployment rate lower and then once the need for these workers is finished they will be fired and the unemployment rate will drift back up to the 10 percent area, said Brian Fabbri chief North America economist at BNP Paribas in New York.

Last month, the services sector added 40,000 jobs after shedding 96,000 positions in December. The figure included a rise in federal government employment, partly a result of early hiring for the Census.

In another positive trend, temporary help employment rose 52,000 last month, while manufacturing payrolls increased 11,000, the first gain since January 2007. Manufacturing employment had dropped 23,000 in December.

But the construction sector continued to struggle, losing 75,000 jobs, likely because of unusually cold weather. Construction payrolls fell 32,000 in December.

In another sign of labor market improvement, the average workweek unexpectedly rose to 33.3 hours, the highest level in a year, from 33.2 hours in December, while manufacturing overtime rose to 3.5 hours, the highest since September 2008.

This suggests that firms are straining to keep up with rising demand without hiring. We believe that as long as orders keep streaming in, at some point soon, firms are going to have to give in and add workers, said Stephen Stanley, chief economist at RBS in Stamford, Connecticut.

(Additional reporting by Ross Colvin in Washington and Jessica Wohl in Cincinnati; Editing by Neil Stempleman)

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