* Jobs data transmits mixed message to Fed watchers
* Caterpillar falls after broker downgrade
* Microsoft drags down S&P 500
* Indexes end down: Dow 1.66 pct, S&P 1.53 pct, Nasdaq 1.05 pct (Adds detail on session, comment, updates prices to close)
By Noel Randewich
Sept 4 (Reuters) - U.S. stock indexes dropped more than 1 percent on Friday after a mixed August jobs report did little to quell investor uncertainty about whether the Federal Reserve will increase interest rates this month.
Trepidation about the first U.S. rate hike in almost a decade added to worries among investors already on edge about a stumbling Chinese economy and a recent market selloff.
"Markets are confused. It was an okay jobs report, but there's worry about China going into the weekend," said John Augustine, chief investment officer, Huntington Trust in Columbus, Ohio.
Nonfarm payrolls increased 173,000 last month, fewer than the 220,000 that economists polled by Reuters had expected. But the unemployment rate dropped to 5.1 percent, its lowest in more than seven years, and wages accelerated. Many investors viewed those data points as contradictory signals about the urgency to increase interest rates.
Near-zero rates have allowed the U.S. stock market to almost triple from the depths of the financial crisis in 2009. Many on Wall Street hope recent global market turmoil and worries about China's economy will lead the Fed to hold off raising rates when it meets on Sept. 16-17.
"In the run-up to its policy meeting, the Fed will pay even greater attention to global market developments - this with a view to minimizing the risk that its words and actions would inadvertently add to market volatility that could spill over into a fragile global economy and weaken it further," said Mohamed El-Erian, chief economic adviser at Allianz.
Following Friday's employment data, futures market traders predicted about a 20 percent chance a rate hike will come this month, down from around 30 percent before the jobs report and from a more than 50 percent probability before world markets started tumbling two weeks ago.
The Dow Jones industrial average ended down 1.66 percent at 16,102.38 points and the S&P 500 lost 1.53 percent to close at 1,921.23.
The Nasdaq Composite gave up 1.05 percent to 4,683.92.
Microsoft was the biggest drag on the S&P and the Nasdaq with a 2.05 percent fall.
All the 10 major S&P sectors were sharply lower with the financial index's 2.03 percent loss leading the decliners. Wells Fargo dropped 2.17 percent and JPMorgan lost 1.88 percent.
In a minor sign of improved sentiment heading into the weekend, all three major indices moved up from lows of around 2 percent in the latter part of the session. But they still ended the week in the red, with the Dow down 3.2 percent, the S&P off 3.4 percent and the Nasdaq falling 3 percent.
Chinese stock markets, ground zero for the recent global selloff, were closed on Thursday and Friday for the 70th anniversary of World War II. U.S. stock markets will be closed for labor day on Monday when Chinese markets reopen.
The CBOE Volatility index, known as Wall Street's "fear gauge", rose 7 percent to 27.41, well above its long-term average of 20.
Caterpillar's shares lost 1.81 percent after Baird downgraded the stock to "neutral".
Netflix fell 2.24 percent in its sixth straight day of losses.
Stock losses have pushed the S&P 500's valuation down to a relatively more attractive 15.4 times expected earnings, compared to around 17 for much of 2015, according to Thomson Reuters StarMine data.
But the outlook for earnings may darken due to concerns stemming from China. Wall Street already expects a 3.4 percent decline in earnings for the S&P 500 this quarter.
Declining issues outnumbered advancing ones on the NYSE by 2,306 to 718. On the Nasdaq, 1,747 issues fell and 1,034 advanced.
The S&P 500 index showed no new 52-week highs and 16 new lows, while the Nasdaq recorded 11 new highs and 65 new lows.
Volume was light. About 6.3 billion shares traded on U.S. exchanges, compared to an average of 7.9 billion in the past five sessions, according to BATS Global Markets. (Additional reporting by Tanya Agrawal in Bengaluru, Sinead Carew in New York and Alexandre Boksenbaum in Paris; editing by Andrew Hay and Chizu Nomiyama)