U.S. productivity growth slowed and labor costs rose sharply in the second quarter, sparking new fears that the Federal Reserve may raise interest rates again next month.

Productivity at non-farm businesses rose at an annual rate of 0.6 percent and labor costs rose at an annual rate of 4.5 percent in the April-June period, according to revised estimates released yesterday by the Labor Department. The department earlier had estimated the productivity growth rate at 1.3 percent.

Stock and bond prices fell on the news, with the Dow Jones industrial average initially dropping more than 200 points. The Dow closed down 94.67 points to end at 10,843.21. Yields on 30-year U.S. Treasury bonds at yesterday's close rose to 6.13 percent, from 6.08 percent.

Strong productivity growth helps keep inflation low by allowing employers to boost wages and salaries without necessarily raising the prices paid by their customers. The second-quarter productivity number was down considerably from the 3.6 percent rate in the first quarter.

Investors apparently were concerned that faltering productivity growth could prompt the Fed to raise short-term rates, as it did at the end of June and again last month, to make sure inflation stays under control.

While it certainly is possible that the Fed will increase rates again when its policymakers meet Oct. 5--as Fed governor Edward W. Kelley Jr. said yesterday in an interview with Market News International--a single weak quarter on the productivity front, by itself, isn't likely to cause that to happen. For one thing, even with the low second-quarter gain, productivity was up 2.8 percent from the same quarter a year ago, up slightly from the 2.7 percent year-over-year increase of the first three months of the year. "In assessing the just 0.6 percent gain in the overall non-farm business sector productivity, it's well worth emphasizing that such data are incredibly volatile on a quarterly basis," said Maury Harris, chief economist at PaineWebber in New York.

The main reason productivity growth slowed so much in the April-June period was the sharp slowdown in overall economic growth. After increasing vigorously for three years, the inflation-adjusted gross domestic product rose at only a 1.3 percent rate in the second quarter, down from a 4.3 percent rate in the first quarter and 6 percent in the final three months of last year.

Such abrupt declines in the nation's production of goods and services almost always show up in productivity since employers can't adjust the hours their employees work to fit every up and down in their customers' demand. If economic growth speeds up again in the second half of the year, as many forecasters expect, productivity growth is likely to reaccelerate too.

The report indicated that productivity growth remains solid in many parts of the economy. For example, productivity--the amount of goods and services produced for each hour worked--at manufacturing firms rose at a 4.8 rate, compared with a 6.8 percent rate in the first three months of the year. The cost of labor going into each item produced in factories rose at a 1.3 percent rate after four consecutive quarterly declines.

At nonfinancial corporations, an economic sector to which Fed Chairman Alan Greenspan pays particular attention, productivity rose at a 2.7 percent rate in the second quarter, down from a 5 percent rate in the first quarter.

Economist Dana Saporta of Stone & McCarthy, a financial markets research firm, noted that the year-over-year growth in average hourly earnings figures taken from the monthly payroll reports has "not accelerated meaningfully" and "thus we do not expect another such rapid increase in compensation [as shown in the government report] over the balance of 1999."

While the figures released yesterday "contain negative news for financial markets, there should be much better news on these fronts over the balance of the year," Saporta said.