Normally, ISM Services PMI isn’t a major focus for the markets. But after what happened on Friday, the markets could be looking closely at one component of the data in particular. Next week is the release of the now all-important CPI figures which will be determinant for what the Fed does at its next meeting. And the Services PMI figure could give some important insight in what’s going on with US inflation.
Last Friday, the markets were focused on NFP, as usual. The unexpected weakness in the US jobs market was seen as a positive sign for the stock market, because it meant that the Fed was less likely to raise rates. But that all switched around a few hours later when the ISM Manufacturing PMI came out. The headline number wasn’t so important as the prices paid component, which rocketed higher, dragging the entire index up with it.
Manufacturers were paying significantly more for products and services, which meant that inflation could still be a concern. Over the last month, the price of crude has been on the rise again, pushing up prices at the pump. Combine that with the unfavourable base effects from last year, then August CPI could jump higher.
But the Fed cares more about the core…
That’s right! Which is why there is focus on the prices paid segment in PMIs: They represent what businesses are paying for raw materials and other input costs. While that can be driven in part by things that are more volatile, like fuel, it has a direct impact on the cost of doing business.
Businesses ultimately need to pass their costs on to consumers or take smaller profits. Both options are negative for financial stability, and would necessitate an intervention from the Fed. Which is why a large change in prices paid can have a larger impact on the market.
What we’re looking for
Another reason why the prices paid component is so important: It’s a larger chunk of the economy. And it’s much closer to the consumer. If manufacturers see rising costs, then there are more steps along the supply like that can help mitigate it. Through diverse cost-cutting measures or simply narrower profit margins, the effect on inflation could be softened.
But there are fewer steps between the suppliers of services and the final consumer, and in many cases the services buyer is the final consumer. For example, a coffee shop. If the cost of manufacturing the coffee machine goes up, then the coffee shop owner might decide to forego buying the machine. That would prevent the cost of the machine going through to the consumer. But if the cost of the beans goes up, then the coffee shop owner either has to take less profits or raise prices. If the shop is running at a very tight margin, then the owner might not have any choice but to raise prices. Therefore, prices paid in the service sector are a bigger risk to cause inflationary pressure.
If ISM Services PMI is pushed up by a large increase in prices, then traders might start pricing in a higher chance of a Fed rate hike. But if prices are in line with expectations or fall, then investors might experience some relief, and the dollar could weaken once more.
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