WRAPUP 3-US services sector expands; price growth accelerates amid tariffs

By Lucia Mutikani

WASHINGTON, March 5 (Reuters) - U.S. services sector growth unexpectedly picked up in February and prices for inputs increased, which combined with a recent surge in the cost of raw materials at factories suggested that inflation could heat up in the months ahead.

Rising price pressures could be worsened by a trade war, triggered by President Donald Trump's new 25% tariffs on imports from Mexico and Canada, which took effect on Tuesday, along with a doubling of duties on Chinese goods to 20%.

The Institute for Supply Management (ISM) survey on Wednesday showed tariffs widely mentioned in comments, with some industries saying the levies had "created chaos" and "great uncertainty about future business activity."

Deep federal government spending cuts also worried business, suggesting that activity could ease in the months ahead. The combination of high inflation and slowing economic growth could paint the Federal Reserve into a corner.

"The Fed faces a tricky balancing act in the months ahead as the economy will likely lose momentum and inflation creep higher in response to new tariffs," said Sal Guatieri, a senior economist at BMO Capital Markets. "The wisest option is to sit tight."

The ISM's nonmanufacturing purchasing managers index (PMI) climbed to 53.5 last month from 52.8 in January. Economists polled by Reuters had forecast the services PMI dipping to 52.6.

A PMI reading above 50 indicates growth in the services sector, which accounts for more than two-thirds of the economy.

The ISM associates a PMI reading above 49 over time with expansion in the overall economy. The PMI pointed to resilience in domestic demand, but was at odds with so-called hard data, including consumer spending and homebuilding that have suggested a sharp slowdown in gross domestic product this quarter.

With the goods trade deficit deteriorating sharply in January, largely blamed on front-loading of imports ahead of tariffs, the Atlanta Fed is currently forecasting GDP contracting at a 2.8% annualized rate this quarter. The economy grew at a 2.3% pace in the fourth quarter.

The White House said on Wednesday Trump had agreed to delay tariffs for one month on some vehicles built in North America.

The Fed's "Beige Book" report described economic activity as having risen "slightly" since mid-January.

"Anxiety continues, however, over the potential impact of tariffs," said Steve Miller, chair of ISM's Services Business Survey Committee.

Some businesses in the accommodation and food services sector reported that "tariff actions have created chaos in information and pricing measures, forecasting and forward buys, which may artificially inflate purchases to be followed by a drop off."

Similar sentiments were echoed by their counterparts in the construction industry who said "implementation of tariffs will have a significant cost impact to our projects," noting that they were "seeing U.S. prices already rise in anticipation."

Some providers of educational services said they were "still digesting the current potential changes with federal assistance programs." In the agriculture, forestry, fishing and hunting industries there was "great uncertainty about future business activity due to the risk of tariffs and other potential government actions."

Sharp spending cuts and funding freezes being pushed by tech billionaire Elon Musk's Department of Government Efficiency, or DOGE, have resulted in mass layoffs of probationary workers at national parks as well as employees at other federal agencies.

U.S. stocks were higher in choppy trade. The dollar fell against a basket of currencies. U.S. Treasury yields rose.

NEW ORDERS RISE

The ISM survey's new orders measure rose to 52.2 from 51.3 in January. That helped to lift its gauge of prices paid for services inputs to 62.6 from 60.4 in January. The ISM reported on Monday that its measure of prices paid by factories jumped to nearly a three-year high in February.

The Trump administration's tariffs on Canadian, Mexican and Chinese goods are expected to raise prices for items as small as avocados to as big as motor vehicles.

Target TGT.N CEO Brian Cornell told CNBC that the retail giant would increase prices "over the next couple of days" on some seasonal grocery products such as avocados from Mexico.

Economists at Nationwide estimated that tariffs against the nation's three major trade partners would increase the cost of goods per household by nearly $1,000 annually.

Consumer prices increased 3.0% year-on-year in January, the largest gain in seven months. Worries that tariffs would raise prices contributed to the U.S. central bank's decision to pause its interest rate cuts in January.

Suppliers' delivery performance slowed last month. The ISM survey's supplier deliveries index increased to 53.4 from 53.0 in January. A reading above 50 indicates slower deliveries.

The survey's measure of services employment increased to 53.9 from 52.3 in January. It has not been a reliable predictor of services payrolls in the government's closely watched employment report, which is scheduled to be released on Friday.

Separately, the ADP National Employment Report showed payrolls increased by 77,000 jobs in February, the smallest gain since July 2024, after rising 186,000 in January. Economists had forecast private employment advancing 140,000.

The ADP report, jointly developed with the Stanford Digital Economy Lab, likely exaggerates the labor market slowdown and has no correlation with the government's employment report.

Nonfarm payrolls are estimated to have increased by 160,000 jobs after rising 143,000 in January, a Reuters survey showed. The unemployment rate is forecast unchanged at 4.0%.

Federal job cuts are not expected to show up in February's employment report as the purges happened outside the payrolls survey week. But hiring and funding freezes could have an impact on government and contractor employment.