By Lucia Mutikani

WASHINGTON (Reuters) - U.S. factory activity contracted in August for the first time in six months as new orders and production tumbled, but a low level of layoffs continued to point to a pickup in economic growth in the third quarter.

While manufacturing remains constrained by the lingering effects of a strong dollar and lower oil prices, sustained labor market strength could push the Federal Reserve closer to raising interest rates later this year.

"Today's disappointing (manufacturing) number further weakens the case for a rate hike later this month, but we currently see no reason to change our Fed call and continue to anticipate a rate hike at the December meeting," said Harm Bandholz, chief U.S. economist at UniCredit in New York.

The Institute for Supply Management (ISM) said its index of national factory activity fell 3.2 percentage points to a reading of 49.4 last month. That was the first contraction since February. The index remains above the 43.2 threshold that is associated with a recession.

A reading below 50 indicates a contraction in manufacturing, which accounts for about 12 percent of the U.S. economy. The dollar's surge between June 2014 and December 2015 as well as weak global demand have crimped export growth.

A collapse in oil drilling activity following a plunge in oil prices has also squeezed manufacturing by undermining business spending, leading to weak demand for heavy machinery. In addition, a U.S. inventory correction has resulted in factories receiving fewer orders.

While sentiment surveys including the ISM and several regional reports have pointed to manufacturing weakness, so-called hard data on oil drilling rigs, durable goods orders and industrial production have offered tentative signs of stability in the sector.

Manufacturing is lagging data on consumer spending and housing that have suggested the economy has regained speed after growing only 1.0 percent in first half of the year.

Last month, the ISM's new orders subindex plunged 7.8 points to a reading of 49.1. Production also slipped into contractionary territory and factory employment shrunk further. But the manufacturing employment downturn has yet to spread to other sectors of the economy.

In a separate report, the Labor Department said initial claims for state unemployment benefits increased 2,000 to a seasonally adjusted 263,000 for the week ended Aug. 27. It was the 78th consecutive week that claims remained below the 300,000 threshold, which is associated with a robust labor market. That is the longest stretch since 1970, when the labor market was much smaller.

The four-week moving average of claims, considered a better measure of labor market trends as it irons out week-to-week volatility, fell 1,000 to 263,000 last week.

"Despite some seeming trouble in the manufacturing sector, the overall outlook for employment is positive," said Michael Gapen, chief economist at Barclays in New York.

The downbeat factory data pushed the dollar <.DXY> lower against a basket of currencies. U.S. stocks were generally weaker, while prices for U.S. Treasuries rose.

AUGUST PAYROLLS

The data came ahead of the release on Friday of the government's closely watched employment report for August, which economists say could determine whether the Fed raises interest rates again later this month or in December.

According to a Reuters survey of economists, nonfarm payrolls likely increased by 180,000 jobs in August after rising by 255,000 in July. The unemployment rate is seen falling one-tenth of a percentage point to 4.8 percent.

August's anticipated step-down in job gains would follow two straight months of payroll increases above 250,000. The U.S. central bank increased its benchmark overnight interest rate last December for the first time in nearly a decade.

In a third report on Thursday, global outplacement consultancy Challenger, Gray & Christmas said employers in the United States announced plans to shed 32,188 workers from their payrolls in August, down from 45,346 in July.

The computer sector dominated the job cuts last month, with Cisco Systems <CSCO.O> announcing plans to reduce its workforce by 5,500 jobs. There were also layoffs in the energy, industrial goods and entertainment and leisure sectors.

In a fourth report, the Labor Department said unit labor costs, the price of labor per single unit of output, increased at a sharper 4.3 percent rate in the second quarter as opposed to the 2.0 percent pace reported last month.

The spike was due to a change in how the data is calculated and probably will not be sustained. Unit labor costs rose 2.6 percent from a year ago.

(Reporting by Lucia Mutikani; Editing by Paul Simao)