Stagflation Warning? US July Services Demand Remains Strong, Costs Surge, But Employment Indicators Contract

The US services sector continued expanding in July, with new orders and business activity accelerating, indicating resilient domestic demand at the beginning of the third quarter.

However, sharply rising input costs and a renewed contraction in employment indicators have highlighted a coexistence of economic growth and inflationary pressures. This supports the Federal Reserve's (Fed) decision to keep inflation control as its primary policy focus, especially as the labor market has not yet shown clear signs of deterioration.

The Institute for Supply Management (ISM) reported on Wednesday (5th) that the July Non-Manufacturing Index rose slightly to 54.1 from June’s 54.0, slightly below the market expectation of 54.5, but still above the 50 threshold that separates expansion from contraction. The services sector accounts for more than two-thirds of US economic activity, and its steady expansion indicates that consumer and business demand remain robust.

US July ISM Non-Manufacturing Index Breakdown: (50 = Expansion/Contraction Threshold)

- Business Activity Index: 59.1 (previous: 55.4) - New Orders Index: 57.2 (previous: 55.1) - Employment Index: 47.4 (previous: 51.2) - Supplier Deliveries Index: 52.8 (previous: 54.4) - Inventories Index: 51.4 (previous: 51.2) - Prices Index: 70.3 (previous: 67.7) - Backlog of Orders Index: 50.9 (previous: 54.9) - New Export Orders Index: 52.0 (previous: 50.4) - Imports Index: 51.8 (previous: 49.4) - Inventory Sentiment Index: 52.5 (previous: 52.6)

New Orders and Business Activity Accelerate: World Cup Provides Short-Term Boost

The ISM Services New Orders Index increased from 55.1 to 57.2, surpassing the expected 55.9. The business activity indicator reached a five-month high. Thirteen service industries reported growth, including retail, transportation & warehousing, and construction, while only four reported contraction.

Rising new orders were also driven by improved export demand, with both export and import indices reaching their highest levels since April. However, the backlog of orders increased only slightly, with growth clearly slowing compared to the previous month. The supplier deliveries index declined from 54.4 to 52.8 but remained above 50, indicating ongoing delays in supplier deliveries, which continue to burden businesses with higher costs.

S&P Global reported that the final reading of the US Services Purchasing Managers’ Index (PMI) for July surged from June’s 51.2 to 54.6—well above the preliminary 53.6—and marked the highest level since October 2025, recording the largest monthly increase since May 2024.

According to S&P Global, the pace of new business growth in the services sector hit a 19-month high, and business confidence in operations over the next year reached its best level since November last year. Private-sector employment rose for the first time since April. Composite PMI data suggest that US GDP could grow at an annualized rate of 2.3% at the start of Q3, up from the 1.5% implied by Q2 surveys.

However, Chris Williamson, Chief Business Economist at S&P Global Market Intelligence, cautioned that part of the July growth acceleration stemmed from temporary factors. Consumer-facing services benefited from the World Cup and Independence Day celebrations, with demand growth hitting its largest increase in over four years. Reduced geopolitical uncertainty and falling oil prices at the beginning of the month also provided support for businesses. However, as Gulf tensions escalated again at month-end, these positive factors may gradually fade.

Soaring Costs, Shrinking Employment: Fed Can Continue Focusing on Inflation

Prices and employment emerged as the most concerning aspects of the ISM report. The July Services Price Index jumped from 67.7 to 70.3, far exceeding the market expectation of 65.0. After the collapse of a temporary US-Iran agreement, oil and gasoline prices rebounded, pushing up service and raw material costs. Ongoing supplier delivery delays further intensified price pressures.

S&P Global’s survey similarly showed the fastest rise in business input costs since November 2022, with composite selling prices increasing at the fastest pace in a year. Economists warn that even if oil prices fall, the AI investment boom could keep underlying inflation elevated.

In contrast to solid demand and rising prices, the ISM Services Employment Index plunged from 51.2 in June to 47.4 in July, below market expectations and marking the largest contraction since March. The index has been below 50 in four of the past five months, suggesting that businesses are adopting a cautious hiring approach amid persistently high costs and squeezed profit margins.

However, the ISM employment index has historically not been a reliable predictor of official service-sector employment figures. Economists describe the current labor market as being in a 'low hiring, low layoffs' state, suggesting that employment has not yet clearly deteriorated, allowing the Fed to prioritize inflation control.

The Federal Reserve (Fed) held the federal funds rate target range at 3.5% to 3.75% last week, but three officials advocated for a 25-basis-point rate hike. Market forecasts expect Friday’s (7th) release of July non-farm payroll data to show an increase of 80,000 jobs, up from June’s 57,000, with the unemployment rate expected to remain at 4.2%.