Manufacturing accounts for 11% of U.S. gross domestic product (GDP) and 8.5% of non-farm employment. This is a big change from 50 years ago when it accounted for 25% of both categories.
Manufacturing’s influence extends beyond the production of goods to transportation, warehousing, and retail networks. The final output of U.S. made goods accounts for about 30% of GDP.
In September, the Institute for Supply Management (ISM) Purchasing Managers Index (PMI), which measures a wide variety of manufacturing data, fell to 47.8%, the lowest level since June 2009. The August reading of 49.1% signaled the beginning of a contraction, the September reading suggested the contraction was accelerating. This index rose slightly to 48.3% in October, indicating the third consecutive month of contraction. A reading below 50% generally means that manufacturing activity is contracting.
The PMI, which tracks changes in production, new orders, employment, supplier deliveries, and inventories, is considered a leading economic indicator that may predict the future direction of the broader economy. Manufacturing contractions have often preceded economic recessions, but the structure of the U.S. economy has changed, with services carrying much greater weight than manufacturing. The last time manufacturing contracted, in 2015 and 2016, the services sector helped to maintain continued growth in the broader economy.
That may occur again this time, but there are mixed signals from the services sector. In September, the ISM mon-manufacturing index (NMI) dropped suddenly to its lowest point in 3 years: 52.6%. The index bounced back in October to 54.7%, marking the 117th consecutive month of service sector expansion. These readings though are well below the 12-month high of 60.4% in November 2018.
The slump is being driven by a variety of factors, including a weakening global economy, the strong dollar, and escalating tariffs on U.S. and imported goods. In October, the International Monetary Fund downgraded its forecast for 2019 global growth to 3%, the lowest level since 2008-09. A weaker world economy shrinks the global market for U.S. manufacturers. The strong dollar, which makes U.S. goods more expensive overseas, reflects the strength of the U.S. financial system in relation to the rest of the world. A strong dollar makes U.S. exports more expensive for foreign buyers.
Tariffs have been effective for some industries. But the overall impact so far has been negative due to rising costs for raw materials and retaliatory tariffs on U.S. exports. U.S. manufacturers in every industry may pay higher prices for imported materials used to produce their products. An average of 22% of “intermediate inputs” (raw materials, semi-finished products, etc. used in the manufacturing process) come from abroad.
Tariffs paid by U.S. manufacturers on these inputs must be absorbed, cutting into profits, and/or passed on to the consumer, which may reduce consumer demands. Along with the specific effects of the tariffs, manufacturers and other global businesses have been hamstrung by trade policy uncertainty, which makes it difficult to adapt to changing conditions and commit to investment. A recent Federal Reserve study estimated that trade policy uncertainty will lead to a cumulative 1% reduction in global economic output through 2020.
Recent actions have delayed the imposition of additional tariffs on Chinese goods, and reports indicate the two sides are attempting to negotiate a limited deal. A deal would be welcomed by most parties, but it’s uncertain how any agreement might affect tariffs already in place or the tariffs on goods from other countries.
Even so, a continued slowdown in manufacturing is unlikely to throw the U.S. into recession as long as unemployment remains low and consumer spending remains high. The key to both of these may depend on the continued strength of the services sector, which employs the vast majority of U.S. workers. It remains to be seen whether the service economy will stay strong in the face of global headwinds that are holding back manufacturing.