The Impact of High Inflation and Interest Rates on the Services Sector

Key Takeaways

• Service sector activity surprised economists in June by being weaker than expected.
• One of the drivers of the slowed activity was new orders, which contracted for the first time in more than a year.
• As in some other parts of the economy, demand is likely being hampered by high borrowing costs set by the Federal Reserve to tame inflation.

Activity in the services sector was weaker than expected in June, as high inflation and the interest rates used to combat it hamper demand. A key survey of service industry leaders declined for the second time in the past three months. Before April, the Institute of Supply Management (ISM) services sector Purchasing Managers’ Index (PMI) had risen for 15 consecutive months. Economists surveyed by The Wall Street Journal and Dow Jones Newswires expected a more modest drop than the nearly 5-percentage-point fall from May.

Economists attributed some of the decline to weaker demand, as the report showed new orders were signaling a contraction for the first time in a year and a half. Services, which include health care, dining, hotel, insurance, finance, and utility businesses, are especially sensitive to changes in consumer spending. Rising prices and increased borrowing costs are significant to these businesses.

What’s the Federal Reserve Got To Do With It?

The central bank has held its influential fed funds rate at a 23-year high in an effort to discourage spending by making it more expensive to borrow money. And it seems to be working. “The Fed will be glad to see that the ISM Services PMI reported cooler inflation, and a little concerned that the economy seems to be losing momentum. But controlling inflation is still the Fed’s No. 1 priority,” Bill Adams, chief economist for Comerica Bank, said.

The services sector is just the latest corner of the economy to weaken recently. Just in the past week, reports showed that construction is being hampered by high interest rates, manufacturing activity is seeing a similar slip, and consumers are growing more concerned about the economy.

Wells Fargo economists Tim Quinlan and Shannon Seery Grein said that while the decline in services activity is something to keep an eye on, it’s not yet cause for alarm. “An optimist looks at this release and sees much of what the Fed is fighting for. Service-sector activity is cooling and giving way to a moderating labor market and ultimately softer price pressure,” the Wells Fargo economists wrote.

Conclusion

The impact of high inflation and interest rates on the services sector is evident in the recent decline in activity. As demand weakens due to rising prices and borrowing costs, businesses in industries such as health care, dining, and finance are feeling the effects. The Federal Reserve’s efforts to control inflation have led to a cooling of economic activity across various sectors, with the services industry being just one of many affected. While economists are keeping a close watch on these developments, there is optimism that this moderation in activity could lead to a more stable labor market and reduced price pressures in the future.

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