U.S. business productivity fell for the first time in 1-1/2 years in the second quarter and labor costs hardly rose, according to government data that underlined the halting pace of economic recovery.

Productivity declined by an annual rate of 0.9 percent after rising at a revised 3.9 percent rate in the first quarter, a Labor Department report showed on Tuesday. It was the first time since the fourth quarter of 2008 output per worker fell.

Other data showed consumers growing increasingly gloomy about the economic outlook while business inventories increased and sales slumped.

Taken together, the reports presented a relatively bleak backdrop for Tuesday's one-day Federal Reserve meeting. Policymakers will discuss how to spur the economy after they already cut interest rates to near zero.

A potential silver lining in the productivity report was the possibility it may soon force more hiring by employers if they have reached the limits of squeezing current workforces.

If working people longer and harder is no longer bringing large returns to businesses, executives may have to find other ways to expand production, said economist Joel Naroff of Naroff Economic Advisors in Holland, Pa.

They might actually have to hire more workers, he added.

Analysts surveyed by Reuters forecast productivity, a measure of hourly output per worker and an indicator of economic vitality, would expand 0.2 percent year on year in the second quarter and unit labor costs would rise 1.3 percent.

SALES SLUMP MEANS LESS REBUILDING

Separately, the Commerce Department said June wholesale inventories rose slightly by 0.1 percent to $399.2 billion but sales dropped 0.7 percent. Inventory restocking has been a driver of the recovery from the worst recession in decades. But falling sales will do little to encourage stockpiling.

Financial market participants focused on the Fed policy meeting and its public announcement around 2:15 p.m. ET. Investors did not show much optimism. Stock prices were down sharply.

A gauge of consumer confidence, the Investor's Business Daily and TechnoMetrica Market Intelligence Economic Optimism Index, slipped to 43.6 in August from 44.7 in July. A reading under 50 signals pessimism and one over 50 is optimistic.

The productivity report showed unit labor costs, a gauge of potential inflation pressures closely watched by the Fed, edged up at a 0.2 percent annual rate after shrinking at a revised 3.7 percent rate in the first three months this year.

But the data pointed to growing pressure on household incomes, which in turn is likely to crimp spending that fuels overall economic activity.

Compensation per hour contracted at a 0.7 percent annual rate in the second quarter and was flat in the first three months of the year.

Weak productivity is in line with other broad signs that the economic recovery is losing momentum. The overall economy grew at only a 2.4 percent annual rate in the second quarter, down from a 3.7 percent rate in the first quarter.

As Fed policymakers met, market participants guessed that the U.S. central bank might be mulling other fresh steps to stimulate the economy amid signs that inflation poses little or no current risk.

Some Fed officials worry that with unemployment stuck at a lofty 9.5 percent, employers will seize the chance to push wages down for those still working and prices will come under pressure, possibly triggering a round of punishing deflation.

(Additional reporting by Emily Kaiser in Washington and Ciara Linnane in New York; Editing by Andrew Hay)

Manufacturing