WASHINGTON (Reuters) - The U.S. unemployment rate unexpectedly dropped to 7.8 percent in September and reached its lowest level since President Barack Obama took office, providing a boost to his re-election bid.

The Labor Department said on Friday that employers added 114,000 workers to their payrolls last month, a moderate number, but it said a combined 86,000 more jobs were created in the prior two months than it had previously thought.

Other aspects of the report also were strong. In particular, a separate survey of households found a big surge in hiring. That pushed the jobless rate down by 0.3 percentage point to its lowest level since January 2009.

"It's a good report. The picture is still not a great one, but it's not so bad given the unusual headwinds that we have been faced with," said Ray Stone, an economist at Stone & McCarthy Research Associates in Princeton, New Jersey.

Obama said the report showed the economy was making progress while his Republican challenger Mitt Romney said the labor market was not healing fast enough.

Businesses have been hesitant to hire out of concern the U.S. recovery could take a hit from a sharp tightening of the federal budget next year, any worsening of the debt crisis in Europe and a slowdown in the global economy.

So far this year, job gains have averaged 146,000 per month, compared with 153,000 per month in 2011.

Economists had expected the unemployment rate to rise to 8.2 percent in September. The drop last month came even as Americans returned to the labor force to resume the hunt for work. The workforce had shrunk in the prior two months.

The household survey, which can be very volatile month-to-month, showed employment increased 873,000 -- the first rise in three months and the biggest since June 1983. But two-thirds of those were Americans who took a part time job even though they wanted full-time work, a fact that took a bit of the shine off the report.

Economists generally pay the most attention to the job growth figures from the much larger survey of employers. Over time, the surveys track each other, although many economists say the household survey sometimes takes the lead when trends shift.

Taken together, economists said the report broadly signaled a healthier labor market. The employment-to-population ratio, or the proportion of the working-age population with a job, increased to its highest level since May 2010.

Stocks on Wall Street initially rose, with the Dow Jones industrial average touching its highest point in almost five years, but they later retreated to close little changed as investors took profits. The dollar hit a two-week high against the yen, while U.S. Treasury debt prices fell.

U.S. interest rate futures also slipped as traders bet an improving jobs market could lead the Federal Reserve to back off its monetary stimulus earlier than had been expected.

A Reuters poll of top bond dealers, however, showed expectations holding firm that the Fed would end up buying $600 billion under a new stimulus program announced last month.

SPIN DOCTORS

There now remains only one more employment report before the November 6 election, and that comes just four days before voters go to the polls.

"We are moving forward," Obama said as he plead his case during a campaign rally in a Washington suburb. "After losing about 800,000 jobs a month when I took office, our businesses have now added 5.2 million new jobs over the past 2-1/2 years."

"This country has come too far to turn back now."

Despite the progress, the economy is still about 4.5 million jobs short of where it stood when the 2007-09 recession started and Romney sought to remind voters that the labor market was still far from healthy.