The U.S. labor market delivered an unexpected setback in July, giving Federal Reserve officials another reason to tread carefully as they consider what to do with interest rates in September.

Employers shed 23,000 jobs last month, according to the latest report from the U.S. Bureau of Labor Statistics. That result was sharply below economists' expectations for an increase of about 80,000 jobs. The figures for May and June were also revised downward by a combined 103,000 positions, revealing that hiring had been weaker than previously reported.

The report has changed the conversation on Wall Street. Rather than focusing almost entirely on persistent inflation, investors are now paying closer attention to the possibility that the labor market is losing momentum.

A Surprisingly Soft Labor Market

The July figures contained some conflicting signals.

The unemployment rate actually declined from 4.2% in June to 4.1% in July. However, that improvement was largely linked to fewer people participating in the labor force. The participation rate fell to 61.4%, its lowest level in nearly five and a half years, after about 264,000 people left the labor force.

Employment also weakened in several areas. Local government education recorded significant losses, while leisure and hospitality employment fell for a second consecutive month. Health care remained one of the sectors adding jobs.

The BLS described overall payroll employment as having changed little in July, compared with an average monthly increase of 34,000 over the previous year.

While one month's figures do not establish a lasting trend, the combination of weaker hiring and downward revisions has made it harder to describe the labor market as comfortably strong.

The Fed Has to Balance Two Risks

The new employment data arrive at a complicated moment for the Federal Reserve.

The central bank has been trying to keep inflation under control without unnecessarily weakening the economy. July's consumer price data offered some encouragement on the inflation side. Consumer prices increased 3.4% over the year, down slightly from 3.5% in June, while core inflation stood at 2.5%.

That creates a difficult calculation for policymakers. Higher interest rates can help contain inflation, but they can also make borrowing more expensive for households and businesses and potentially place additional pressure on hiring.

Before the jobs report, investors had been assigning greater odds to a September rate increase. The weaker employment figures quickly changed those expectations, sending Treasury yields lower as markets reduced their bets on another hike.

The Fed's July meeting had already revealed disagreement among policymakers. Three members of its policy-setting committee preferred a quarter-point increase, while the majority voted to keep the benchmark rate in the 3.50% to 3.75% range.

More Data Could Decide the September Move

The latest jobs report does not settle the question.

The Federal Reserve will have additional economic information to examine before its September 15 to 16 meeting, including further inflation and employment indicators. Policymakers will need to determine whether July's weakness represents a temporary slowdown or the beginning of a more significant deterioration.

For workers and businesses, the distinction matters. A prolonged slowdown could eventually affect hiring opportunities, wages and consumer spending. For investors, meanwhile, expectations surrounding interest rates can influence everything from bond yields to stock prices and borrowing costs.

For now, the labor market has given the Fed a new reason for caution. Inflation remains above the central bank's 2% target, but the latest employment figures suggest that the economy may not be strong enough to absorb higher borrowing costs without consequences.

The September decision will therefore require the Fed to look in two directions at once: keeping inflation from gaining ground while making sure its efforts to control prices do not push the labor market into deeper trouble.