Productivity Follows Greenspan Out the Door

Talk about timing. The long-time Fed chief exits, and worker output is already in the tank.
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No sooner does Alan Greenspan make his exit from the

Federal Reserve

than the motivation of the American worker follows him out the door.

Jesting aside, an unexpected decline in fourth-quarter productivity appears to have been at least one of the very real factors behind a sharp drop in the stock market on Thursday. Not only did nonfarm productivity drop 0.6%, the first decline since early 2001, but unit labor costs rose 3.5% in the fourth quarter, reviving concerns about inflation.

With costs rising while productivity drops, "firms will attempt to offset these pressures through higher prices (inflation)" or face a "reduction in profit growth," according to Wachovia chief economist John Silvia.

To many traders, that could spell the end of a virtuous cycle of increasing productivity, which Greenspan had identified in the last decade. He had also used it to justify keeping rates low enough to allow the economy to grow and profits to expand for longer than in previous business cycles.

"Productivity has been this huge issue for the market, and people remember Greenspan highlighting it in the 1990s," says Owen Fitzpatrick, head of U.S. equity strategy at Deutsche Bank.

Stock prices also suffered a big midmorning drop amid rumors, since denied, that the Department of Homeland Security was about to raise the nation's terror alert level following new threats from Al Qaeda.

As the rumors swirled, the

Dow Jones Industrial Average

plunged 130 points to a morning low of 10,827.16 before rebounding once the government put an end to that particular worry. The Dow, however, remained under pressure, recently trading down 84 points, or 0.8%, at 10,869. Strong January sales at

Wal-Mart

(WMT) - Get Report

didn't even help the giant retailer's stock, which was recently off 0.6%.

The

S&P 500

was shedding 10.11 points, or 0.8%, at 1272.35, but was off a low of 1267. The

Nasdaq Composite

, down 24.77 points, or 1.1%, at 2285.79, was about 9 points above its worst level of the day.

Contributing to the market's nervousness is the continuation of tension over Iran's nuclear ambitions and the possibility of United Nations sanctions, which could potentially impact the supply of crude from the world's fourth-largest oil producer.

The latest development now has Iran telling the International Atomic Energy Agency that it will end voluntary cooperation with the IAEA if the watchdog group takes its case to the U.N. Security Council.

However, the price of crude was falling following news of rising U.S. inventories. In recent action, crude was down 86 cents at $65.70 a barrel. That also contributed to broader market weakness, as the Amex Oil index lost 2.1% and energy shares weighed on the S&P 500. The pullback was exacerbated by broker downgrades of

Sunoco

(SUN) - Get Report

and

Murphy Oil

(MUR) - Get Report

.

But generally speaking, as geopolitical anxiety remain elevated, so will energy prices. And that's not good news just as other inflationary pressures, such as labor costs, seem to be on the rise.

"A squeeze on profits and a lack of ability to absorb high commodity prices leading to inflation ... seems to be the reading the market had of the

productivity numbers," Fitzpatrick says.

For Ben Bernanke, it's only his second day as the new chairman of the Fed, but it looks like the outcome of his first meeting as the central bank's leader could already be decided. Beyond the productivity numbers, economic data for January increasingly point to a first-quarter rebound from the weakness experienced in the last three months.

Additionally, news of the strength in last month's chain-store sales and a drop in last week's jobless claims -- ahead of the all-important jobs report Friday -- suggest that Bernanke's first move will be to deliver another rate hike, taking the fed funds target rate to 4.75% from the current 4.50%.

Expectations that the Fed will take its key short-term interest rate to 5% have also started creeping into the market, according to Miller Tabak. Odds that 5% will be reached by Bernanke's second meeting in May now stand at 20%. The chance that the 5% level will be hit in June is 46%.

For much of January, the stock market priced in a "goldlilocks" scenario of cooling economic growth, rising profits and no inflation, which would take the Fed out of the picture. As February begins and a new Fed chairman takes over, it's as good a time as any to review those expectations.