NEW YORK (Reuters) - U.S. services sector activity slowed to a 6-1/2-year low in August amid sharp drops in production and orders, pointing to slowing economic growth that further diminished prospects for an interest rate hike from the Federal Reserve this month.

Tuesday's downbeat report from the Institute for Supply Management (ISM) came on the heels of data last week showing a slowdown in job growth in August, a contraction in factory activity and weak automobile sales.

"It is beginning to look as if the economy went on vacation in August," said Joel Naroff, chief economist at Naroff Economic Advisors in Holland, Pennsylvania. "The August data are troubling and they have to concern the Fed. There is no compelling reason for the Fed to raise rates in two weeks."

The ISM said its non-manufacturing activity index fell 4.1 percentage points to a reading of 51.4, the lowest since February 2010. The drop from July was the largest monthly fall since the 2008 financial crisis, with the ISM saying a majority of companies had noted a slowing in their level of business.

A reading above 50 indicates expansion in the sector, which accounts for more than two-thirds of U.S. economic activity.

After the report, interest rate futures <FFU6> were pricing in a 15 percent probability of a rate increase at the Fed's upcoming Sept. 20-21 meeting. The odds for a December rate hike were even.

The U.S. central bank lifted its benchmark overnight interest rate at the end of last year for the first time in nearly a decade, but has held it steady since amid concerns over persistently low inflation.

The dollar dropped against a basket of currencies on Tuesday's data, while prices for U.S. government debt rose. U.S. stocks were trading higher.


The ISM reported last week that factory activity contracted in August for the first time in six months. The ISM manufacturing index, however, remains above the threshold associated with a recession.

Economists said while the ISM surveys did not directly feed into the calculation of gross domestic product, the weak August readings suggested economic growth could be slowing.

The Atlanta Fed is forecasting GDP rising at a 3.5 percent annual rate in the third quarter. The U.S. economy grew 1.0 percent in the first half of the year.

"This makes us very nervous for the third quarter. Growth might still be strong. There are good reasons to believe it will be, such as the rebound in mining-related investment and the strength of exports," said Paul Ashworth, chief U.S. economist at Capital Economics in New York. 

Last month's sharp slowdown in services industry activity reflected a 7.5 percentage points decline in the production subindex, the largest drop since November 2008, when the financial crisis was roiling the global economy.

Activity was also weighed down by decreases in employment and new orders measures. Backlog orders and new export orders contracted last month. Inventories shrank in August after 16 consecutive months of growth.

The ISM said 11 industries, including utilities, real estate, finance and insurance, health care & social assistance, information and professional, scientific and technical services reported growth last month.

The seven industries reporting contraction included transportation and warehousing, wholesale trade, retail trade and arts, entertainment and recreation.

Retailers described the business environment as having "softened a bit over the last month," while respondents in professional, scientific & technical services said they were still recovering from the renewable energy market downturn.

Some economists believe the report exaggerated the services sector's weakness.

"While this report is a little disappointing, it is important to note that the index had been running a little hot compared with underlying economic activity. As such, we expect a modest rebound in future ISM readings," said Gregory Daco, head of U.S. macroeconomics at Oxford Economics in New York.

(Reporting by Lucia Mutikani and Dan Burns; Editing by Meredith Mazzilli)