Productivity climbed at a slower-than-expected pace in the second quarter and has gained only slightly over the past year, keeping alive the risk that rising wages could push up inflation.

The lackluster productivity growth helped keep the Federal Reserve focused on inflation, and not the slackening economy, as it opted on Tuesday to hold benchmark interest rates steady. The Fed said inflation was its biggest worry despite tightening credit conditions and growing downside risks to the economy.

The Labor Department said non-farm business productivity, a gauge of how much any given worker can produce in an hour, rose at a 1.8 percent annual pace in the second quarter.

That was somewhat slower than Wall Street economists had expected and came on the heels of just a 0.7 percent advance at the start of this year as the economy nearly stalled.

Unit labor costs, watched closely by the Fed as a key measure of inflation and profit pressures, grew at a 2.1 percent pace in the second quarter as 3.9 percent growth in hourly compensation outstripped the rise in productivity.

While the labor-costs gain marked a slowdown from a 3 percent first-quarter advance, some analysts said it was still fast enough to present an inflation concern. More importantly, unit labor costs are up 4.5 percent from a year ago, the biggest rise in seven years.

This productivity report definitely confirms the inflation fears of the Fed, said Harm Bandholz, an economist for UniCredit Markets and Investment banking in New York.

U.S. government bond prices fell and the dollar edged up as investors saw the data and the Fed's focus on inflation suggesting less of a chance of a near-term cut in interest rates than many had been betting on. Stocks closed up slightly as the Fed's faith in the economy soothed jangled nerves.

SOFT PRODUCTIVITY TREND

The report does show that productivity improved in the second quarter, but still is growing only modestly and labor costs are still growing -- probably at the high end of the Fed's comfort zone, said Gary Thayer, chief U.S. economist at A.G. Edwards & Sons in St. Louis.

The Labor Department took into account recent downward revisions to the government's measure of U.S. economic growth for the past years, and adjusted its productivity measures lower, as well.

Productivity growth has slowed gradually over the past four years. In the past 12 months, it has grown only 0.6 percent.

It will take a longer period of sluggish growth to unwind inflation pressures, said Scott Anderson, senior economist at Wells Fargo.

While some economists worry the long-term trend of U.S. productivity growth has moved lower, others argue a slowdown is typical during this stage of the business cycle.

We should not forget that we are nearly six years into the current expansion. That is a long time and productivity tends to slow as the expansion wears on, said Joel Naroff of Naroff Economic Advisors in Holland, Pennsylvania.

The underlying pace of productivity growth shapes the economy's long-term growth potential, the rate at which the economy can grow without sparking price pressures.

(Additional reporting by Alister Bull)

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