US services sector softens, factory orders boosted by defense

WASHINGTON (Reuters) - The U.S. services sector barely grew in May as new orders slowed, pushing a measure of prices paid by businesses for inputs to a three-year low, which could aid the Federal Reserve's fight against inflation.

Meanwhile, factory orders rose for a second straight month in April, but aside from a jump in orders for national defense, overall manufacturing activity was soft, in keeping with private survey data showing the sector now in a prolonged downturn.

The Institute for Supply Management (ISM) said on Monday its non-manufacturing PMI fell to 50.3 last month from 51.9 in April. A reading above 50 indicates growth in the services industry, which accounts for more than two-thirds of the economy. Economists polled by Reuters had forecast the non-manufacturing PMI would edge up to 52.2.

Though the PMI remains above the 49.9 level, which the ISM says over time indicates growth in the overall economy, last month's slowdown heightened the risks of a recession. The ISM reported last week that its manufacturing PMI was stuck below the 50 threshold in May for the seventh straight month, the longest such stretch since the Great Recession.

The services sector has benefited from consumers shifting spending after splurging on goods during the height of the coronavirus pandemic when social activities such as dining out and traveling were restricted. But following 500 basis points worth of interest rate increases from the Fed since March 2022, consumers could be focusing more on basic needs.

"Momentum had been very strong in the services sector since the reopening process began, but the sector is clearly cooling down now," Thomas Simons, U.S. economist at Jefferies, wrote in a note. Simons observed that looking past a one-off weak reading in December and the drops in the spring of 2020 as the pandemic began, the ISM readings in the last three months were the weakest since January 2010.

A measure of new orders received by services businesses fell to 52.9 last month from 56.1 in April. With demand cooling, services inflation also slowed. This is good news for the U.S. central bank's efforts to bring inflation down to its 2% target.

The services sector is at the center of the battle against inflation, as services prices tend to be stickier and less responsive to rate hikes. A gauge of prices paid by services businesses for inputs dropped to 56.2, the lowest level since May 2020, from 59.6 in April.

Some economists view the ISM services prices paid gauge as a good predictor of personal consumption expenditures (PCE) inflation. The Fed tracks the PCE price indexes for monetary policy. Financial markets see more than a 70% chance that the central bank will keep its policy rate unchanged at its June 13-14 meeting, according to CME Group's FedWatch Tool.

Services sector employment declined in May. That was, however, at odds with so-called hard data showing persistent strength in the labor market.

The government reported on Friday that nonfarm payrolls increased by 339,000 jobs in May, with private service-providing employment rising by 257,000 jobs. There were 1.8 job openings for every unemployed person in April. First-time applications for state unemployment benefits remain very low.

DEFENSE FUELS FACTORY ORDERS

A 36% jump in defense capital goods bookings buoyed the otherwise lackluster factory orders report for April that was released on Monday by the Commerce Department.

Factory orders increased 0.4% after a 0.6% gain in March, the Commerce Department said. Economists polled by Reuters had forecast orders would rise 0.8%. Orders increased 1.4% through April from a year earlier.

Excluding the defense sector, orders were down 0.4%, and excluding transportation orders - where military orders again had the largest footprint - bookings were down 0.2%.

With consumer spending shifting more toward services, consumer goods orders slid for a third straight month to their lowest level since February 2022.

A proxy for business spending plans on equipment, however, did show improvement. Orders for non-defense capital goods excluding aircraft rose 1.3% in April, although that was fractionally lower than a preliminary gain of 1.4% reported last month.

Shipments of these so-called core capital goods, which are used to calculate business equipment spending in the gross domestic product report, rose 0.5%, unchanged from what was previously reported. Business spending on equipment has contracted for two straight quarters.

(Reporting by Lucia Mutikani and Dan Burns; editing by Chizu Nomiyama and Paul Simao)