Services Sector’s Surprise Comeback Hides Cracks as Inflation Stays Stubborn
Services Sector’s Surprise Comeback Hides Cracks as Inflation Stays Stubborn
The U.S. services industry bounced back in October with surprising energy, but don’t be fooled by the shiny headline numbers. Beneath the surface, the story gets messier—demand is heating up, yet companies aren’t hiring, order backlogs are shrinking at recession-like speeds, and inflation refuses to cool down. It’s a strange mix that’s giving the Federal Reserve a serious headache just as markets are betting on easier monetary policy ahead.
The Institute for Supply Management (ISM) reported that its Services Purchasing Managers’ Index jumped to 52.4% in October, up sharply from 50.0% in September. Economists had expected only a small gain to 50.8%. Since any reading above 50 signals expansion, this marks the eighth growth month of the year for a sector that makes up about 70% of the U.S. economy. Statistically, that translates into roughly a 1.2 percentage point boost to annualized real GDP—a welcome change after months of sluggish growth.
But look closer and the glow fades. New orders soared to 56.2%, the highest level in a year, helped by a flurry of tech mergers, new data center projects, and a burst of end-of-fiscal-year spending from federal agencies. Business activity rose to 54.3% after dipping into contraction earlier. Eleven of eighteen industries reported growth, especially those closest to consumers—accommodation, retail, wholesale trade, and healthcare. These have been the steady performers in the post-pandemic recovery.
Still, the employment picture tells a different tale. The Employment Index fell again, marking its fifth straight monthly contraction at 48.2%. When businesses truly believe demand will hold up, they hire more people. Here, they’re not. Instead, they’re chewing through existing orders without adding staff, suggesting they think this demand pop won’t last. Meanwhile, the Backlog of Orders Index plunged to 40.8%, the second-lowest level since mid-2009, dropping a sharp 6.5 points in one month. And inflation? The Prices Index surged to 70.0%, its highest mark since October 2022, signaling relentless cost pressures. That’s the 101st straight month of rising input costs and the eleventh consecutive month above 60%.
A Core Contradiction
The contradictions within this report are hard to miss. Survey chair Steve Miller summed it up bluntly: “The continued contraction in the Employment Index shows a lack of confidence in the continued strength of the economy.”
In a genuine expansion, rising demand pushes firms to hire. Instead, they’re working through backlogs without bringing in more people. This suggests they see the surge as temporary—perhaps a side effect of fiscal-year quirks, tariff-related timing, or delayed projects finally moving rather than sustained growth.
Think about it: New Orders climbed to 56.2%, yet Backlogs collapsed to 40.8%. That means companies completed more work than they received, something possible only with a burst of productivity or unused capacity. And the survey responses point to the latter. Several firms admitted they’re not replacing workers who leave and that new return-to-office rules are raising retention costs.
The ongoing federal government shutdown, now dragging into its fifth week, isn’t helping. Respondents cited project delays and even hinted at “mass furloughs” if funding doesn’t resume soon. Key sectors tied closely to government spending—public administration, finance, construction, and management services—all reported contractions. According to the Congressional Budget Office, each additional week of shutdown adds unrecoverable GDP losses. In short, the private sector’s strength is happening despite Washington, not because of it.
Inflation: The Fed’s Persistent Problem
Among all the data, that 70.0% Prices Index number stands out most. It landed just eight days after Fed Chair Jerome Powell warned that December’s rate cut is “not a foregone conclusion.” Markets didn’t take it well—bonds sold off, wiping out October’s rally. And now, hot services inflation hands the Fed fresh ammunition to delay any easing.
What’s driving these price increases matters. This isn’t demand-pull inflation from an overheated economy. Exports and imports both fell, to 47.8% and 43.7% respectively, and backlogs tumbled. Instead, companies are blaming tariffs on engineered and manufactured goods, plus rising labor costs in technical and maintenance services. Sixteen of eighteen industries said input costs rose.
This kind of inflation—cost-push, not demand-driven—is the trickiest for the Fed. It limits their flexibility. Cutting rates to cushion growth could easily backfire, stoking even more inflation. Markets betting on a 70% chance of a December rate cut may want to think twice.
The ripple effects are already visible. The dollar remains firm against weaker currencies because U.S. data isn’t matching the cooling inflation stories seen in Europe or Asia. Short-term Treasury yields are drifting higher as traders rethink rate-cut odds, likely flattening the yield curve as the middle maturities cheapen rather than the long end rallying.
Sectors Show a Split Personality
Stocks tell their own story. The rebound is concentrated in consumer-driven businesses—retail, healthcare, and wholesale trade—while interest-rate-sensitive or government-dependent sectors like finance, construction, and public administration are still shrinking. That split offers a clear playbook: focus on companies tied to domestic spending, and avoid those reliant on federal contracts or business investment.
The divergence also explains why manufacturing, which has now contracted for eight months straight at 48.7%, hasn’t dragged the entire economy down. Services are carrying the load. But that concentration brings risk. The U.S. economy now leans heavily on one engine—if services falter, there’s no backup.
What to Watch Next
Three things will decide whether this October rebound has legs or fizzles out.
First, jobs. If the employment index stays below 50 while orders keep rising, it signals a late-cycle economy—one where productivity, not hiring, drives growth. Second, the government shutdown. If it ends before Thanksgiving, the index could get a half-point bump. If it drags into 2026, those “mass furloughs” could send it tumbling. Third, corporate guidance. During earnings season, pay close attention to whether companies complain about tariffs pushing up costs. If they do, the Fed could be staring down a stagflation trap—slowing growth and stubborn inflation, the worst of both worlds.
So, what does all this mean? The October ISM Services report doesn’t show a roaring comeback. It shows resilience—an economy still expanding despite policy snags and rising prices. That’s good news for short-term growth, but a thorn in the Fed’s side as it tries to steer inflation down without crushing demand. Markets cheering the top-line number might be missing the bigger picture: this isn’t the start of a fresh boom, but a balancing act that could tip either way.
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