Growth in worker productivity slowed in the spring to its weakest pace in a year, while a key measure of wage pressures rose sharply, according to numbers announced yesterday. The combination ignited fears in financial markets that inflation may be gathering steam and interest rates may be headed upward.

The figures showed that the output of workers fell even as they were being paid more to produce--an inflationary trend.

Productivity among non-farm workers rose at a 1.3 percent annual rate in the second quarter, down from a revised 3.6 percent annual rate in the first quarter, the Labor Department reported. Meanwhile, unit labor costs--what companies pay workers for each unit of their output--surged 3.8 percent in the quarter, after a revised 0.8 percent increase in the first three months of the year.

Investors initially reacted negatively to the Labor Department report, driving the Dow Jones industrial average down more than 100 points in morning trading before a recovery in battered technology shares helped the index recover. The Dow ended the day up 119.05 points at 10,793.82.

Nasdaq stocks, particularly Internet shares, went on a wild ride, plunging precipitously in the early hours before regaining some composure around lunch time. The Nasdaq composite index rose 25.83, to 2565.83.

While some economists said the Labor Department data were the result of a slowing in the growth of the economy--growth in output of goods and services decelerated from a 4.3 percent annual rate in the first quarter to 2.3 percent from April to June--they still expressed concern about rising wages in an economy with the lowest unemployment levels in decades.

That worry could be exacerbated today, when the government releases the unemployment rate for July. Some forecasters believe it will be 4.2 percent, just below the 4.3 percent registered in June and matching the lowest rate in 29 years--another inflationary trend.

The jitters on Wall Street reflect the unclear nature of the economy. Although losing some of its vigor, the economy may not be cooling sufficiently to dampen inflation worries and calm nerves at the Federal Reserve Board. The economy's continued strength was evident in two other reports, one showing same-store retail sales rose 6.9 percent in July, the other that the number of people filing first-time jobless claims remained at the second-lowest level in two years.

In recent testimony to Congress, Federal Reserve Chairman Alan Greenspan warned the central bank would have to act "promptly and forcefully" if evidence suggests the tightness in labor markets is adding to inflationary pressures.

The Fed's policymaking committee meets on Aug. 24 to consider interest rates. When it met last, in June, it decided to raise the overnight bank lending rate by a quarter of a percentage point. Many economists believe the Fed committee will raise interest rates again this year, but some predict the move may come not in August but later this year, when a clearer picture emerges on whether the economy has slowed down from the breakneck pace of the first quarter.

The quarterly productivity numbers are also known to be volatile. On a year-over-year basis, productivity actually rose by 2.9 percent, up from the first quarter's 2.7 percent rate of gain from the year-earlier period.

Still, the spring labor cost numbers and another recent report showing the fastest pace of growth in wages and salaries since early in this decade makes the Fed's job only more difficult, said economist Chris Varvares at Macroeconomic Advisers in St. Louis.

"The seat they're sitting on is getting hotter," he said.

For at least two years now, gains in worker productivity have outpaced gains in wages, allowing companies to maintain or increase their profit margins even in the face of higher costs for employees. Economically, this is the best of both worlds: Workers prosper with higher wages and companies profit from getting more bang for their bucks.

Productivity growth is one reason corporate profits have remained strong, keeping the stock markets trading at historically high valuations. Any change in that dynamic--whether from a slowdown in productivity or a rise in wages, or both together--could seriously undermine stock prices.

"It will be tough for most companies to pass these higher costs on in the form of higher prices," said Charlie Crane, chief market strategist at Key Asset Management. "So if you can't raise your prices and your productivity is good but not improving, it does imply your profit margins are going to get pinched a bit."

Diane Swonk, senior economist at Bank One Corp., suggested the economy might be undergoing just this "transition," wherein the effects of tight labor markets are beginning to overwhelm the benefits of low inflation and low interest rates.

Swonk believes the deceleration of the economy in the second quarter can be largely attributed to businesses working off their inventories, a process that she thinks will reverse itself in coming months.

Once that process gets underway and the rebound in Asian economies begins to take hold with higher exports of U.S. goods to that region, the domestic economy should pick up steam in the final months of the year, Swonk said. Her firm is predicting third-quarter output growth of 4.1 percent, with an even stronger fourth quarter.

"We will see stronger productivity in the second half" as output increases, Swonk said.

"But we could be at a turning point," she added. "From the Fed's perspective, we're moving in shades of gray on inflation but financial markets move in black and white, which is why they are so schizophrenic these days."