UPDATE 1-U.S. commercial paper market smallest in 2 months

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NEW YORK Aug 26 (Reuters) - The U.S. commercial paper market shrank to its smallest size in two months as a slowing economy cooled demand for business credit, according to Federal Reserve data released on Thursday.

For the week ended Aug. 25, the size of the U.S. commercial paper market, a vital source of short-term funding for companies' day-to-day operations, fell by $23.7 billion to $1.087 trillion outstanding from the previous week.

In addition to sluggish bank lending, credit growth has been curbed by companies reducing spending and their reluctance to hire workers on fears of a double-dip recession.

The commercial paper market, while it has stabilized, has been halved since its peak of about $2.2 trillion in August 2007 before the eruption of the global credit crisis.

The bulk of the market shrinkage in the latest week came from the nonfinancial and asset-backed sectors.

Asset-backed commercial paper outstanding fell $13.0 billion in the week ended Wednesday to $427.8 billion while nonfinancial unsecured CP fell by $10.4 billion to $149.3 billion.

Outstanding short-term debt issued by banks and other financial companies fell by $200 million to $510 billion in the week ended Aug. 25. (Reporting by Richard Leong; Editing by James Dalgleish)