Following Thursday's news that productivity dropped for the first time in five years, investors may not look kindly upon Friday's employment report if it shows strong job growth.

Not only did nonfarm productivity drop 0.6%, but unit labor costs rose 3.5% in the fourth-quarter, reviving concerns over profits, inflation and the likely path of monetary policy.

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

The weak productivity report contributed to weakness in stocks Thursday as traders worried about the end of a virtuous cycle of increasing productivity that former

Fed

chairman Alan Greenspan has long identified as so crucial to growth without inflation.

"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.

These concerns helped set a negative tone to stock trading on Thursday. 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 after 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 heavy selling pressure and finished down 101 points, or 0.9%, at 10,851. Strong January sales at

Wal-Mart

(WMT) - Get Report

helped the giant retailer's stock rise 0.3%. But this was one of only three rising issues in the blue-chip average along with

Boeing

(BA) - Get Report

and

J.P. Morgan

(JPM) - Get Report

.

The

S&P 500

dropped 11.62 points, or 0.9%, to 1270.84, slightly off a low of 1267. News of rising U.S. crude oil inventories sent the barrel down 86 cents to $65.70 and also contributed to weakness in the broad index. The pullback was exacerbated by broker downgrades of

Sunoco

(SUN) - Get Report

and

Murphy Oil

(MUR) - Get Report

.

Losses were heavier in the

Nasdaq Composite

, which shed 28.99 points, or 1.25%, to 2281.57, 4 points above its worst level of the day. Techs may also be under pressure Friday after

Amazon.com's

(AMZN) - Get Report

sales missed expectations after the close. Amazon's shares were recently down 10% in after-hours trading.

Electronic Arts

earnings also came in below expectations, but its shares were up 1.7% after hours.

Given the drop in productivity, Friday's report on January employment may not offer much comfort to investors. Economists on average expect the economy to have added 250,000 jobs in January, compared with 108,000 in December. Average hourly earnings are seen rising 0.3%, matching the previous month's gains, and the unemployment rate is seen steady at 4.9%.

Wall Street is already viewing upside risks to these forecasts, especially after Thursday's news that jobless claims fell more than expected last week, reaching their lowest level in six years.

In recent months, market reaction to the jobs report has been fairly subdued. But that could change now that the

Federal Reserve

has signaled that interest rates have likely reached a so-called neutral level, where they neither stimulate nor restrain growth, according to Joseph Abate, economist at Lehman Brothers.

This tells the market that future monetary policy moves will be dictated by economic data, and few reports carry as much weight as the monthly job tallies. Additional uncertainty has been added by this week's exit of Alan Greenspan and the transition to Ben Bernanke, who remains untested as Fed chairman.

Abate says that a normal market reaction to a surprise in the jobs report is about a 10 basis point move in the price of 10-year Treasuries. A stronger-than-expected report would lead to a decline in the bond price, and a weak report would lead to a rise.

On Thursday, bond prices mostly held steady after the productivity and jobless claims numbers, as selling pressure was offset by safe-haven buying following the terror alert rumors.

The stock market's reaction to the jobs report would be harder to gauge. For much of January, the stock market was in rally mode. The market has priced in a "Goldlilocks" scenario of cooling economic growth, rising profits and no inflation, and that would take the Fed out of the picture.

Although fourth-quarter profits and guidance have been coming in mixed, the economy seems to be rebounding from fourth-quarter weakness. Meanwhile, the next time the market will hear from the Fed is when Bernanke testifies to Congress in two weeks.

Add to this global geopolitical tensions keeping crude oil prices elevated, which fuel fears about inflation and/or profits, and "you've got a market that's a little nervous," says Jay Susskind, director of trading at Ryan, Beck & Co.

In this context, the market will likely want to see a jobs report that still points to a Goldlilocks economy. In other words, the report must be "just in line" with estimates, or else we could be in for another frightful Friday.

In keeping with TSC's editorial policy, Godt doesn't own or short individual stocks. He also doesn't invest in hedge funds or other private investment partnerships. He appreciates your feedback;

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