updated 8/8/2006 2:42:23 PM ET 2006-08-08T18:42:23

The efficiency of American workers slowed sharply in the spring while a key gauge of labor costs rose at the fastest rate since late 2004.

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The Labor Department reported that productivity — the amount of output per hour of work — slowed to an annual rate of increase of 1.1 percent in the April-June quarter, down from a 4.3 percent rate of increase in the first three months of the year.

Labor costs, as measured by each unit of output, rose at an annual rate of 4.2 percent in the spring, the fastest increase since the final three months of 2004 and up sharply from a 2.5 percent rate of increase in the first three months of this year.

Economists said the slowdown in productivity growth and the acceleration in labor costs was certain to raise concerns at the Federal Reserve about the potential for rising inflation.

"It turns out that tight labor markets do indeed lead to faster pay gains," said Stephen Stanley, chief economist at RBS Greenwich Capital, who predicted that core inflation rates will remain higher than the Fed would like for some time to come.

Productivity is the key factor determining rising living standards. Strong growth in output allows businesses to pay their workers more without having to raise the cost of their products, which fuels inflation.

The growth in productivity is often cited by the Federal Reserve as a reason that inflation pressures have been contained. But the combination of slowing productivity and rising labor costs is a recipe for rising inflation pressures down the road.

Federal Reserve policy-makers on Tuesday left the federal funds rate unchanged, calling at least a temporary halt to 17 consecutive interest rate increases over the past two years.

The 1.1 percent rate of increase in productivity in the second quarter was slightly higher than the 0.9 percent rise that economists had been expecting. The 4.3 percent productivity growth rate in the first quarter represented an upward revision from an earlier estimate that productivity grew by 3.7 percent in the first quarter.

The spring increase was the slowest gain since productivity actually fell at an annual rate of 0.1 percent in the fourth quarter of 2005, a quarter when the nation's output slowed sharply in the wake of last year's devastating hurricanes.

The slowdown in productivity growth in the second quarter was also linked to a sharp slowing in overall economic growth, from a sizzling 5.6 percent rate in the first quarter to just a 2.5 percent economic growth in the spring.

Since the mid-1990s, productivity has accelerated as the economy has benefited from the growing use of high-tech tools such as computers and the Internet.

The new report incorporated revisions to productivity growth for the past three years, reflecting data revisions to the gross domestic product for those years.

The new data show that productivity increased by 2.3 percent in 2005 following a gain of 3 percent in 2004 and 3.7 percent in 2003.

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