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By Kenneth Rapoza, Forbes Blog,

This might be the kind of bubble you want, one in which nearly the entire country has a job despite an economic slowdown. Brazil’s unemployment rate is at historic lows, under 6%. Wages are rising, adding to inflation as working class consumers spend. In an event in Paris last week, Brazil’s Minister of Finance Guido Mantega said that while Brazil did not face a credit bubble — a warning that the International Monetary Fund made public last month — its labor market was “a little overheated”.

Mantega’s comments got analysts over at Nomura in New York thinking. Tony Volpon, a senior strategist for Latin America, says that Brazil’s labor markets are more than “a little” overheated. “In fact we see evidence of bubble-like behavior in recent wage and hiring increases. If there is one place in the Brazilian economy where a bubble has developed, this is it,” Volpon said in a note to clients on July 13.

What would constitute a bubble in a labor market? As an input to the productive process, companies hire extra staffers until its cost is equal to a maximum of its marginal product value. If the company wants to keep its widget making profit margins at 10 in order to pay shareholders and keep the lights on, then in theory it shouldn’t hire more staff employees if margins are lowered below the company target.

Expecting greater revenue growth is not by itself a sufficient reason to hire more workers, since the cost of the marginal labor being hired (considering its productivity) is growing faster than marginal revenues. In these conditions companies will see their profit margins squeezed. This should lead companies to lower their demand for labor, either by hiring or by paying less or by substituting capital for labor, Volpon says.

Are Brazilian companies over-estimating demand for Brazilian goods abroad and in the local market? The economy has slowed from over 7% growth last year to 5.1% growth for the 12 months ending in the first quarter and is expected to top out at 4% this year. Yet, the labor market is going gangbusters even as the economy is clearly cooling off. The strong demand for labor may be a temporary result of Brazilian companies refusing to translate slower economic growth to their estimates of demand for their own goods and services. When, and if, they realize this mistake, production in Brazil will slow.

Recent Central Bank monetary policy maker meeting minutes has been more focused on briging inflation to the center of the target in 2012, which would put it at around 4.5%. Statements by Mantega hint that any end of year inflation result below the top of the inflation band of 6.5% is OK with him, so long as inflation is not over that, and it won’t be. The recent decision to extend the current inflation target into 2013 with no change, even though it is one of the highest and widest among inflation targeting countries, is another signal that disinflation is not an overarching policy priority in Brazil, Volpon thinks.

“And most damaging, the decision to maintain for next year the double indexation of the minimum wage, which will see this key benchmark for wages in the red-hot service sector rise by something close to 14% in nominal terms next year,” he said, adding that the minimum wage increase, put off this year, will provide another boost to inflation by giving people even more money to spend.

From Volpon’s report at Nomura:

While we think the above factors may well explain still strong labor demand in an environment of falling growth and productivity, this demand is still ultimately unsustainable. There is no escaping the fact that paying up for less productive labor inputs in an environment of falling real growth will generate profit margin compression. Firms may indeed find it harder to find qualified workers, and so act as if demand curves are upward sloping (the true configuration of bubble-like behavior in any market), but paying more as prices rise is self-defeating behavior and will be reversed as profits fall. We believe this is part of the explanation as to why Brazil‟s Bovespa index is one of the worst performing of the major equity markets in the world this year. Labor market behavior may have acquired bubble-like characteristics in Brazil, but as growth continues to falter and the lagged effects of monetary policy tightening continue to hit the economy, and especially the already over indebted consumer, labor market conditions will finally weaken.