Services Sector Posts Weaker Activity, Even as Costs Are Rising

The latest report card on the services sector of the U.S. economy shows a pullback in business activity and employment, even as input costs are rising. (Drew ANGERER / AFP via Getty Images)

The latest report card on the services sector of the U.S. economy shows a pullback in business activity and employment, even as input costs are rising. This indicates the Federal Reserve could have challenges to keep economic conditions on track in the months ahead if pricing pressures persist.

The Institute for Supply Management reported Tuesday that its Purchasing Managers’ Index for services providers barely managed to stay in expansion territory, registering a reading of 50.1 last month. That’s a 0.7 percentage point dip from the June figure of 50.8 and meaningfully lower than the 51.3 expansion expected by economists surveyed by FactSet.

Perhaps more important than the headline reading, the latest data show that business activity, employment, and new-order indexes fell last month, even as input costs paid by service providers rose. In fact, the prices-paid index rose further to 69.9 last month, its highest level since 2022 when inflation peaked.

Tariff effects are “intensifying” in the services sector, writes Alexandra Brown, North America economist for Capital Economics. She noted that the higher reading is consistent with super-core services inflation—which excludes housing, food, and energy prices—rising to near 4% year over year by the end of 2025, up from 3.3% in recent readings.

“The employment index’s continued contraction and faster expansion of the prices index are worrisome developments,” acknowledged Steve Miller, chair of the Institute for Supply Management. For much of the year, economists and Fed officials have expressed concerns that President Donald Trump’s aggressive tariff policies and anticipated slowdowns in economic activity could lead to stagflationary conditions where employment and economic growth slows, even as inflation rises.

That could make it difficult for Fed policymakers to address weak growth with the usual medicine of cutting interest rates, for fear that makes inflation worse.

The ISM Services employment index was in contraction territory for the second consecutive month, declining 0.8 percentage points to 46.4 in July. That compares with the 47.2% reading in June, and largely matched the weakness in the labor measure from the ISM manufacturing index that dropped to the weakest level since June 2020.

The weak labor signals in the ISM data reinforce the soft initial estimate of July payroll data released on Friday that revealed U.S. employers added just 73,000 jobs last month. According to the Bureau of Labor Statistics, employment in the manufacturing sector declined by 11,000. The private-services sector added 96,000 jobs last month, but it was heavily concentrated in healthcare. Leisure and hospitality job growth remained relatively stalled.

The weak July ISM employment readings also don’t bode well for the upcoming August jobs report, writes James Knightley, chief international economist at ING.

“If we weight them 90% for services and 10% for manufacturing, we see that these readings are historically consistent with non-farm payrolls dropping by more than 100,000,” Knightley wrote. “While the relationship with payrolls hasn’t been as strong since the pandemic, at the very least it suggests we should be braced for soft jobs growth through the second half of the year at the very least.”

That could be further exacerbated by the fact that federal government payrolls are expected to decline substantially in the coming months as layoffs take effect, and workers who accepted the severance packages from Department of Government Efficiency exit the payrolls.

Still, while services providers are reporting that price components are elevated due to tariffs currently, Knightly doesn’t anticipate that inflation pressures will be sustained. Therefore the weaker labor signals will likely prompt the Fed to respond with rate cuts.

The Federal Open Market Committee will meet Sept. 16-17. Odds that Fed officials cut interest rates by a quarter percentage point were about 88% following Tuesday’s ISM Services data release, according to the CME FedWatch tool.

Write to Megan Leonhardt at megan.leonhardt@barrons.com