Manufacturing survey shows inflation worries adding to pressure on Fed

A burst in factory activity shows the U.S. economy may be escaping the burden of tariffs and gaining manufacturing jobs, while at the same time laboring under the geopolitical uncertainty that some industry leaders say is worse than the Covid pandemic.

In its July survey of the manufacturing landscape, the Institute for Supply Manufacturing reported the fastest pace of growth in more than four years — a 55.6 reading that was the best since May 2022 and above Wall Street expectations for 54.0. The index measures the percentage of companies reporting growth, so anything above 50 represents expansion.

Leading the way were strong gains in new export orders, backlogs and a 6.3-point spike in production. At the same time, the employment gauge hit its highest since August 2022 and marked an expansion for the first time in 33 months, ISM officials said.

But concerns lurked beneath the surface of an otherwise positive report.

The prices index edged lower, but only to 71.1, indicating that nearly three-quarters of all respondents reported that prices were heading still higher, the 22nd straight month that has happened.

Moreover, the commentary pointed to a highly volatile environment in which purchasing managers were struggling to stay ahead of events like the Iran war and tariffs.

‘Nothing but’ price increases

“No normalcy in sight in the world of metals,” an executive in the primary metals sector said. “It makes me yearn for the coronavirus pandemic chaos, which was more manageable than whatever this is that we are in.”

A manager in the electrical equipment, appliances and components industry voiced similar concerns.

“The pricing volatility and lead-time extensions in this market are arguably worse than the pandemic era,” the respondent said. “During Covid-19, we saw a surge of price hikes and inventory buy-ups, which caused constraints that eventually leveled out.”

This time around, “We are seeing nothing but consistent upward trends for both pricing and lead times that show no signs of slowing down,” the manager said.

The ISM survey lists respondents by industry but not by name.

From a policy standpoint, the manufacturing industry dynamic presents a challenge to the Federal Reserve that several analysts found likely to bolster the case for an interest rate increase soon.

A solid economic picture with ongoing price pressures could push Fed Chairman Kevin Warsh and his colleagues into a hike as soon as September, particularly considering the seeming stability of the labor market. Around this time last year, officials were expressing substantial worry over a flat hiring picture, leading to three consecutive rate cuts starting in September.

Inflation data for June was fairly positive, as a short pause in Middle East tensions drove down energy prices and shelter costs continued to moderate. However, virtually all pricing gauges show inflation still well above the Fed’s 2% target.

The Federal Open Market Committee last week voted to hold its key overnight interest rate in a range between 3.5%-3.75%, where it has been all year.

Hike still in question

“If trade is less of a drag this quarter and businesses restock inventories, economic growth could reach 2.2% in the third quarter. As a result of demand-induced inflation and energy supply shortages, the Warsh-led Fed will be pressured to raise rates on September 16,” wrote Jeffrey Roach, chief economist at LPL Financial.

Troy Ludtka, senior U.S. economist at SMBC Nikko Securities Americas, noted that the boost in the production index put it at its highest level since November 2021.

“Strong payroll growth from two of the most interest rate sensitive sectors [manufacturing and construction] will enable the Fed to continue its hawkish communication drift,” Ludtka wrote.

Following the ISM report, Goldman Sachs said it is tracking third-quarter economic growth at 2.4%, up from the initial estimate of 1.5% for the second quarter.

Traders, though, remained at least a bit skeptical of a coming rate hike in the wake of comments from Warsh last week that many market participants saw as ambiguous at most, in terms of the Fed’s intentions. Odds for an increase at the Sept. 15-16 meeting of the FOMC stood at 64.5% midday Monday, down slightly from Friday, according to the CME Group’s FedWatch.

Still, analysts see continued inflation pressure likely forcing the central bank’s hand.

“Companies continue to complain about the pricing environment, and this report shows that this is not changing much,” wrote Richard de Chazal, macro analyst at William Blair. “From the Fed’s perspective today’s [ISM] report should help tilt the scales further toward tightening policy at the September FOMC meeting.”