U.S. services sector slows modestly, trade deficit narrows sharply

(Recasts with services data, adds analyst comments, markets)

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Services sector activity slows slightly in September

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ADP private payrolls increase 208,000

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Trade deficit shrinks 4.3% to $67.4 billion

WASHINGTON, Oct 5 (Reuters) - The U.S. services industry slowed modestly in September while employment surged and a measure of prices paid by businesses for inputs fell to more than a 1-1/2-year low, suggesting underlying strength in the economy despite rising interest rates.

That was underscored by other data on Wednesday showing private employers increased hiring last month. The trade deficit also narrowed in August to the lowest level in more than a year amid falling imports, prompting Goldman Sachs to boost its third-quarter gross domestic product tracking estimate by a full percentage point to a 1.9% annualized rate.

"Rate hikes are meant to slow the economy and labor demand enough to fight inflation," said Will Compernolle, a senior economist at FHN Financial in New York. "The services side of the economy appears too resilient to suggest the kind of slowdown the Federal Reserve wants."

The Institute for Supply Management (ISM) said its non-manufacturing PMI dipped to a reading of 56.7 last month from 56.9 in August. Economists polled by Reuters had forecast the non-manufacturing PMI would fall to 56.0.

A reading above 50 indicates expansion in the services sector, which accounts for more than two-thirds of U.S. economic activity. The U.S. central bank has hiked its policy rate from the near-zero level at the beginning of this year to the current range of 3.00% to 3.25%, and last month signaled more large increases were on the way this year.

Services activity is being supported by a shift in spending from goods. Fifteen industries, including mining, public administration, retail trade, information and construction, reported growth. But accommodation and food services, arts, entertainment and recreation, as well as transportation and warehousing reported a decline in activity.

While job openings dropped by 1.1 million, the largest decline since April 2020, to 10.1 million on the last day of August, demand for labor remains strong.

Professional, scientific and technical services business reported that "hiring continues to be a challenge across most industry sectors," adding that "there are far more open roles than candidates to fill them." Businesses in the healthcare and social assistance sector said "labor pressures continue to depress business activity, as insufficient staffing levels are not allowing the hospital system to operate at capacity."

The ISM report's services industry employment gauge shot up to 53.0 from a reading of 50.2 in August, suggesting job growth was likely solid in September. That expectation was supported by the release on Wednesday of the ADP National Employment Report, which showed private employment increased by 208,000 jobs last month after rising by 185,000 in August.

Stocks on Wall Street were trading lower. The dollar rose against a basket of currencies. U.S. Treasury prices fell.

SOLID LABOR MARKET

The Labor Department's more comprehensive and closely watched employment report on Friday is expected to show nonfarm payrolls increased by 250,000 jobs in September, according to a Reuters survey of economists. The economy created 315,000 jobs in August.

"The labor market remains solid, but job growth is slowing in the second half of 2022 to a more sustainable pace," said Gus Faucher, chief economist at PNC Financial in Pittsburgh. "The key question is whether the Fed can raise rates enough to slow job growth and inflation without pushing the U.S. economy into recession."

The ISM report's measure of new orders received by services businesses slipped to 60.6 from 61.8 in August. Some of the decrease was likely due to some businesses holding too much inventory on their shelves and in warehouses as high inflation forces customers to cut back on spending.

Wholesalers reported that though inventory levels were starting to drop from record highs, "overstocked items are still a problem," adding that "we expect lower demand and inventory rebalancing to impact business activity through the end of the calendar year." Inflation was hurting spending in the accommodation and food services industry as well as agriculture.

Supply chains continued to ease, but retailers as well as the transportation and warehousing industry are still facing shortages. The ISM survey's measure of supplier deliveries fell to 53.9 from 54.5 in August.

Services inflation decelerated further last month. A gauge of prices paid by services industries for inputs dropped to 68.7, the lowest reading since January 2021, from 71.5 in August, raising hopes that inflation had peaked, though the descent will probably be slow.

A third report from the Commerce Department showed the trade deficit narrowed 4.3% to $67.4 billion in August, the lowest level since May 2021.

The smaller trade deficit could spur a rebound in GDP after it contracted at a 0.6% pace in the second quarter.

Imports declined 1.1% to $326.3 billion, likely driven by slowing demand and unsold goods.

There were big declines in crude oil and capital goods imports. Motor vehicle imports, however, increased and were the highest on record. Imports of services rose, lifted by gains in travel and charges for the use of intellectual property.

"The real volume of imports has fallen at a 19.0% annualized rate over the last five months," said Conrad DeQuadros, a senior economic advisor at Brean Capital in New York. "Such a decline in imports is unprecedented outside of recessions, but we do not see the U.S. economy as being in recession."

With tighter monetary policy boosting the dollar by 10.7% against the currencies of the United States' main trade partners since the start of the year, U.S.-manufactured goods are becoming less competitive.

Exports slipped 0.3% to $258.9 billion, also reflecting slowing demand in Europe and elsewhere. The decline in exports occurred almost across the board, with large decreases in non-monetary gold, crude oil and motor vehicles and parts.

But exports of consumer goods increased, mostly reflecting pharmaceutical preparations, while exports of capital goods were the highest on record. Exports of services fell as gains in business and financial services were offset by a drop in travel.

(Reporting by Lucia Mutikani; Editing by Chizu Nomiyama and Paul Simao)