Economic growth slowed significantly in the second quarter while wages increased at the fastest pace since the early 1990s, the government reported yesterday. The news led to a sell-off on Wall Street as investors feared the Federal Reserve was more likely to raise interest rates again.
At first glance, the slowing in the annual rate of growth in gross domestic product from its 4.3 percent clip in the first three months to 2.3 percent in the spring appeared to be a development that would satisfy Federal Reserve Chairman Alan Greenspan, who has been counting on a chilling of the economy to forestall the need for any further increases in interest rates.
But financial markets passed over that possibility and instead focused on a 1.1 percent increase in the employment cost index (ECI), a broad measure of wages and benefits. The index rose at a rate greater than the 0.8 percent analysts had expected--and raised the specter of inflationary pressures increasing in an economy that already is experiencing the tightest labor market in decades.
The Dow Jones industrial average fell 180.78 points, to 10,791.29, as investors worried that the markets' benign environment of strong economic growth and weak inflation was undergoing a sea change. The technology-dominated Nasdaq composite index slumped 65.83, to 2640.01, and the Standard and Poor's 500-stock index tumbled 24.37, to 1341.03.
The bond market also soured on the news, with the price of the benchmark 30-year Treasury bond falling $7.81 per $1,000 in face value and the yield rising to 6.07 percent, from 6.00 percent on Wednesday.
"The market is choosing to ignore the GDP number and focus on the ECI number, in my opinion, principally to take profits," said Philip Orlando, chief investment officer at Value Line Asset Management. "This is just a one- or two-day wonder."
Analysts had anticipated GDP growth would be about 3.2 percent, off the quicksilver pace of the first quarter, when a surge of consumer spending drove the economy to new heights. But a slowdown in government spending, along with more restrained purchases by consumers, contributed to a sharper falloff in growth.
Wages and benefits, meanwhile, accelerated from the very slow growth of the first quarter, when the index rose 0.4 percent. Strong increases in pay and benefits for workers in the financial services industry helped drive the index higher.
Some analysts said the quarterly index is volatile and that a more accurate picture of wage trends can be obtained by averaging out the numbers for the past six months, which shows no real change in the pace at which wages and benefits are rising. Year over year, wages have been rising about 3 percent.
"I think the numbers are not as bad as the markets are taking them," said Gary Thayer, chief economist at A.G. Edwards & Sons Inc. in St. Louis. "The ECI tends to be real volatile quarter to quarter. I don't think this is a sign of accelerating inflation."
Thayer's remarks were echoed by other economists, who noted the Fed would probably look most closely at the part of the GDP report measuring final sales, or the demand for goods and services from domestic purchasers. If demand slows sufficiently--and the second-quarter report showed it had cooled to about half the pace of the fourth quarter of last year--then eventually production and business inventories will adjust accordingly.
"The GDP data indicates that the long-awaited slowdown has finally arrived," said National Association of Manufacturers economist Gordon Richards. "The fundamentals, however, remain strong. The economy should continue on a path of stable expansion."
Still, the market reaction showed just how sensitive investors have become to the notion of rising inflation in an economy nearing a record for a peacetime expansion. The sell-off comes a day after Greenspan told Congress that the Fed was ready to raise interest rates further if inflation picks up.
The Fed last month nudged the overnight bank lending rate by a quarter of percentage point, to 5 percent, and some people on Wall Street are convinced it will raise it again when its policymaking committee meets next month.
"It affects market psychology going forward," Elliott Platt, chief investment officer at Donaldson, Lufkin & Jenrette Inc., said of the wage index. "The first-quarter numbers were clearly aberrational. But this adds to fear of the Fed firming. The market had been cruising along."
Platt said he now believes the overnight bank lending rate, known as the fed funds rate, will now be increased to 5.50 percent in a series of moves. That would bring it back to where it was before the Fed cut rates last fall to offset turmoil in the bond market after Russia's partial default on its debt.
Other analysts believe that with growth moderating, and given the volatile nature of the employment index, the Fed was unlikely to raise rates at its next meeting.
"Bond yields are certainly headed to 6.25 percent by the end of the year," Platt said, referring to the interest paid out on the 30-year Treasury bond. "For the stock market, it probably means some bad days ahead."
The GDP report did show a clear deceleration in housing activity, one sector of the economy that reacts quickly to changes in interest rates. After rising at a 15.4 percent annual rate in the first three months of the year, spurred on by unusually warm winter weather, spending on residential construction grew at a more modest 5.1 percent annual rate in the second quarter. Some economists have suggested purchasers rushed to buy houses earlier this year as mortgage rates began to rise.