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LONDON — U.S. businesses outside the manufacturing sector have started to report slower growth, as faster inflation, rising interest rates and heightened concern about the economic outlook hit household and business spending.

The Institute for Supply Management’s non-manufacturing index slipped to 54.4 in October (the 35th percentile for all months since 1997) from 56.7 in September (66th percentile) and 66.7 a year ago (99th percentile).

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The non-manufacturing index, which covers businesses in services, transportation, construction, mining and farming, fell to its lowest level since May 2020, when the economy was in the first wave of the pandemic.

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The employment component slipped to 49.1, the third time in five months it has fallen below the 50-point threshold dividing expanding activity from a contraction.

Service sector activity is highly correlated with the manufacturing sector: the correlation between the ISM’s manufacturing and non-manufacturing indices (both averaged over three months) is 0.8.

Many services are provided to the manufacturing sector and supply chain, and both respond to the same macroeconomic oscillations.

Services are following manufacturing into a marked slowdown after two years of exceptionally rapid recovery from the pandemic-induced recession.

Chartbook: U.S. service sector activity

LOSING MOMENTUM FAST

Most cyclical indicators show the U.S. economic expansion decelerated rapidly over the course of the third quarter and at the start of the fourth.

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Real final sales to private domestic purchasers (FSPDP) increased at an annualized rate of just 0.1% in the third quarter, down from 2.1% in the same period in 2021, and the slowest rate since 2009.

Real personal incomes less transfer payments (PILT) were up by less than 0.7% in the three months from July to September compared with the same period a year earlier.

The increase in PILT was in only the 19th percentile for all three-month periods since 1980, confirming sluggish growth in consumer incomes after allowing for inflation.

So far, labor market indicators continue to show solid growth, but employment is a lagging indicator in most business cycles.

BRACE FOR HARD LANDING

The Federal Reserve has already raised its target for overnight inter-bank interest rates to 3.75-4.00%, up from 0.00-0.25% at the start of the year, the fastest increase in borrowing costs for 40 years.

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Interest rate traders anticipate the target will increase further to 5.00-5.25% by the middle of 2023, and stay above 4.00% throughout the rest of 2023 and 2024 as the central bank tries to wring excess inflation out of the economy.

By continuing to increase interest rates aggressively even as the business cycle loses momentum rapidly, the central bank is piloting the economy towards a relatively hard landing.

But personal consumption expenditure (PCE) inflation was running at more than 4% in the third quarter, double the Fed’s target of 2.0%, and labor-intensive services inflation was running at almost 5%.

Policymakers clearly believe they must risk a hard landing to get inflation back under control quickly before it becomes more entrenched in wage and price-setting processes.

Related columns:

– Recession by any other name will still reset the economy (Reuters, Nov. 2)

– U.S. manufacturing cycle likely peaked in third quarter (Reuters, Oct. 28)

– U.S. service sector inflation decelerates but remains high (Reuters, Aug. 10)

John Kemp is a Reuters market analyst. The views expressed are his own (Editing by David Evans)