Stocks took a beating yesterday after a Labor Department report showed that labor costs for businesses rose more than predicted in the second quarter.
The report re-ignited fears that the Federal Reserve will boost interest rates again, maybe as soon as its next meeting, Aug. 24.
A separate Commerce Department report, which at first blush seemed to show the U.S. economy was cooling, was nearly as troubling; under closer scrutiny, it became clear growth was virtually unchanged, economists said.
"This is going to be very helpful to the Fed, which wants to tighten, but which might not have been able to" given some other reports showing that growth wasn't overheating, said Mark Vitner, economist for First Union Corp. in Charlotte, N.C.
The Labor Department's Employment Cost Index, or ECI, the broadest measure of wage, salary and benefit costs, grew an unexpected 1.1 percent in the second quarter after a first-quarter increase of 0.4 percent. Economists were predicting an increase of only 0.8 percent.
The second-quarter ECI jump was the largest since a 1.2 percent increase in the second quarter of 1991. By contrast, the first-quarter rise was the smallest since the government began tracking this statistic in 1982.
The mildly negative outlook sent the Dow Jones industrial average tumbling 180.78 points, or 1.7 percent, to 10,791.29, and the Nasdaq composite index fell 65.83 points, a steeper 2.4 percent, to 2,640.01. Interest rate-sensitive financial stocks and pricey technology shares were among the hardest hit.
The Commerce report initially appeared promising to investors who don't want to see interest rates increased, but it also turned into a big disappointment. It said that gross domestic product grew at a smaller-than-expected 2.3 percent annual rate in the second quarter, well off the 4.3 percent pace in the first three months of the year. Gross domestic product, or GDP, is a key way to measure how fast an economy is growing.
The 2.3 percent growth rate for the second quarter was less than the 3.4 percent economists had forecast and was the lowest since the same quarter last year. But several factors skewed the GDP growth figure: very low growth in inventories, a big drop in the rate of government spending and a bigger trade deficit.
Lower inventory growth lowers GDP, because inventories are a component of measuring output. And because the government is a big buyer of goods and services, slower increases in the rate of spending cut into the rate of growth. A higher trade deficit also erodes GDP growth, because the value of imports is subtracted from exports in calculating what the domestic economy produces.
But all three factors masked the strength of the U.S. economy during the second quarter, analysts said. They found the decline in inventory growth unusual, but said that means either the number will be revised upward next quarter or it will result in even higher shipments during the third quarter to replenish inventories.
The big drop in the growth of government spending also was unusual, economists said, and it, too, is likely to move back to its normal level in the third quarter.
And even though higher imports reduce overall GDP growth, somebody's buying those imports, which means inflation-inducing spending isn't necessarily slowing.
When those three things are factored in, GDP growth probably jumps from an annualized rate of 2.3 percent to as much as 3.2 percent -- about what was expected.
But it was the big jump in labor costs that really spooked investors. Federal Reserve Chairman Alan Greenspan has told Congress that the nation's central bank was prepared to "act promptly and forcefully" if indicators show "that the pace of cost and price increases will be picking up."
Labor costs -- wages and benefits -- account for two-thirds of consumer prices. A subset, wages and salary costs, increased 1.2 percent in the second quarter, the most since the second quarter of 1990.
In the Fed's view, with unemployment low and companies having to pay more to hire workers, a continued upward march in wages could be inflationary.
At its last session June 30, the Fed's Open Market Committee raised the overnight bank lending rate a quarter-point to 5 percent. It next meets Aug. 24 and some market watchers believe another rate increase is almost inevitable.
Rate increases could lead to a hurtful drop in stock prices, thanks to two long-running stock-market maxims: "Three steps and a stumble" and "Don't fight the Fed." The first holds that three rate increases -- or "steps" -- will lead to a stock-market "stumble."
The second advises investors to not "fight" the Fed by holding stocks when the central bank is raising rates. The reason: Stocks are generally hurt by higher rates, even in normal times, since those rates generally translate into more attractive yields for less-risky, competing investments such as money market funds or certificates of deposit.
And with stocks -- especially Internet stocks -- still expensive by virtually any historical measure, times are not normal now, said Richard Cripps, chief market strategist for Legg Mason Inc.
If rates are increased several times, or more than investors expect, "then we're perilously close to the edge," he said.
Bloomberg News contributed to this article.