Market's Focus on ECI Drives Triple Whammy

But in the end, the slowing economic growth apparent in the GDP report will mean more.
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The market could have heaved a collective sigh of relief after a report on the

gross domestic product

showed economic activity moderated much more in the second quarter. The market instead focused on a slightly larger-than-anticipated rise in the

employment cost index

, or ECI. The reaction helped spark a triple whammy as U.S. equities, bonds and the dollar all fell hard.

Most market participants had been looking for around 3.5% growth in Q2. The economy expanded at an annual pace of 2.3% -- the weakest performance since Q2 last year. That should have been good news, easing fears the economy is overheating. The report's GDP deflator, a measure of inflation itself, should have helped do that job. It rose at a 1.6% annualized rate, the same as in Q1.

This was not to be the case. The market myopically focused instead on the 1.1% rise in the ECI. The consensus had expected a 0.8%-0.9% increase. The year-over-year rate rose to 3.2% from 3.0% in Q1. The market hastily concluded that based on this report, the

Federal Reserve

is significantly more likely to raise rates at its Aug. 24 policy-setting meeting.

Wrong. Even though market lore says the ECI is among Federal Reserve chairman Alan Greenspan's favorite economic indicators, he probably reads it quite a bit differently than short-term market speculators. For example, as someone who is acutely aware of the swings in the data, Greenspan and his colleagues at the Fed likely will place the Q2 rise in the context of the record low 0.4% rise in Q1. When taken together, the increase in the EIC in the first half was in line with the quarterly average of about 0.8% over the past three years. Just as the low reading in Q1 didn't spur ideas of a more accommodative monetary policy, the higher reading in Q2 is unlikely to lead to a tighter monetary policy.

Employment costs can rise without fueling a general increase in the prices as long as productivity remains strong. Based on the GDP report and the employment figures for Q2, unit labor costs (which put the wage bill in the context of output) are probably rising at around a 1% rate on a year-over-year basis. Not quite the stuff that cost-push inflation is made.

Looking Past the ECI

After the dust settles, it will be the GDP report that has the most significant implications. At the same time the U.S. economy appears to be moderating, Japan and Europe growth prospects are improving.

The market has come to believe the long overdue recovery in the Japanese economy is finally at hand. Even if Q2 does not sustain the momentum that boosted the Japanese economy at a heady 7.9% annual pace in Q1, most market participants believe the Japanese economy has turned the corner. Both monetary and fiscal policy will remain accommodative to ensure that the growth cycle catches and is sustained.

In recent weeks the data from Germany and France, on balance, has led the market to believe the two largest economies in the eurozone are also recovering. Although there has been some speculation lately that the

European Central Bank

may tighten policy later this year, most observers, including me, do not expect that until Q1 2000 at the earliest. More likely, later this year, the ECB will allow the market to have greater influence over the overnight rate instead of fixing it, as is currently being done. In any event, the market is increasingly confident that interest rates have hit bottom in the eurozone and the U.K.

Growth differentials were the key fundamental factor helping to drive the dollar higher in the foreign-exchange market during the first six and a half months of the year. Today's U.S. data will encourage the market to have greater confidence that growth differentials have peaked. It will contribute to resolving the debate between those who think the recent bounce in the euro is a technical correction in a bear trend and those, like myself, who are more inclined to believe dollar is no longer in an uptrend.

The U.S. debt and equity markets are likely to recover from today's losses. Portfolio managers are reportedly sitting on plenty of cash and are likely to begin deploying it at the beginning of next month. In contrast, the dollar's best days are probably behind us.

Marc Chandler is the chief currency strategist for Mellon Bank. At the time of publication, he held no positions in the currencies or instruments discussed in this column, although holdings can change at any time. While he cannot provide investment advice or recommendations, he invites you to comment on his column at

commentarymail@thestreet.com.