US Services Sector Grows, But So Does Inflation

The U.S. service sector grew in May for a second straight month, exceeding Wall Street expectations but showing a worrying surge in inflation pressures.

The report supports inflation worries expressed on Tuesday by Federal Reserve Chairman Ben Bernanke and suggests that the U.S. central bank may have to turn its focus to reining in price growth from warding off recession.

The Institute for Supply Management said its non-manufacturing index came in at 51.7 in May versus 52.0 in April. That was above the level of 50 that is the dividing line between growth and contraction.

"We have been getting stronger than expected data over the past couple of weeks, both from the manufacturing side and now from the services side," said Michael Pond, Treasury and inflation-linked strategist at Barclays Capital in New York.

"Data overall has been quite inconsistent with calls back in March that the U.S. was entering a prolonged recession." Economists had expected a reading of 51.0 for May, according to the median of their forecasts in a Reuters poll. The 76 forecasts ranged from 48.5 to 53.0.

Stocks were flat on Wall Street and the dollar got a slight lift after the report.

U.S. government bonds, which perform better during weak economic times, extended their losses after the ISM report.

Underpinning concerns with inflation, the prices paid index rose to 77.0 in May, the second-highest reading in the report's 11-year history.

It was up from 72.1 in April and the rise also contributed to bond-market losses.

The services sector represents about 80 percent of U.S. economic activity, including businesses such as banks, airlines, hotels and restaurants.

Earlier, the government reported that U.S. productivity grew at a slightly faster-than-expected 2.6 percent annual rate during the first quarter on stronger output than was initially gauged.

Economists polled by Reuters had expected non-farm productivity, which measures the hourly output per worker, to increase at a 2.5 percent pace, compared with a previously estimated 2.2 percent rate.

Compared with the first quarter of 2007, non-farm productivity was up 3.3 percent, the quickest pace in nearly four years.

The Labor Department said first quarter output was revised higher to show a 0.7 percent gain at an annual rate, from 0.4 percent previously reported. Worker hours shrank 1.8 percent as businesses cut back on labor inputs to shield profits amid a cooling U.S. economy. It was the third straight quarterly decline in hours.

Unit labor costs, a gauge of inflation and profit pressures closely watched by the Federal Reserve, rose by 2.2 percent at an annual pace, faster than the 2.0 percent rate forecast by analysts.