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The U.S. manufacturing sector shrank again in February, but at a slower rate than in previous months, a sign that activity may be starting to stabilize. 

The Institute for Supply Management (ISM) on Wednesday released its monthly PMI survey, which showed activity rising to 47.7 in February, a slight improvement from the 47.4 seen in January but still in contractionary territory. A reading below 50 indicates a drop in manufacturing activity.

For months, manufacturing activity has fallen because of softening demand for goods, owing to a mix of higher costs for raw materials and disagreements between buyers and sellers over prices. At the same time, the ISM noted that the slower decline in activity could be attributed to higher demand from abroad and more suppliers working through a backlog of orders.  

The uptick in manufacturing is the latest sign that the U.S. economy is continuing to show resilience after months of warning signs that suggested a recession was forthcoming. This recent data follows a much stronger than expected January jobs report and an increase in consumer spending after a slump late last year. However, the increase in prices is likely to complicate efforts by the Fed to bring down inflation.

“This report is an indication that the inflation story is not going away that easily,” said Oscar Munoz, a U.S. macro strategist at TD Securities. 

In a sign that demand is holding firm, the survey's new orders sub-index rose to 47, up from 42.5 recorded in January. Of the six largest manufacturing sectors surveyed, an increase in new orders was concentrated in petroleum and coal products and transportation equipment. The ISM's price index also clocked in at 51.3, up from 44.5 in January, a boost that can be attributed to the rise in raw material prices, said Munoz. 

These demand pressures can in part be attributed to the recent re-emergence of China after over a year of diminished manufacturing activity. Since lifting the last of its strict anti-pandemic measures in January, the Chinese economy has seen a steady upswing in activity. On the same day the ISM data was released, China’s own unofficial manufacturing index came out and showed its fastest rise in new orders since May 2021.

"What we are seeing is that China is back online," said Jay Bryson, a managing director and chief economist at Wells Fargo. 

Despite these challenges, firms have been loath to part with their workers. The ISM’s data on employment dipped to 49.1 from 50.6 in January, but survey respondents reported that there still remained a 2-to-1 ratio of hiring to layoffs. Survey respondents chalk this up to an expectation that manufacturing activity will pick up in the second half of 2023 on the back of improving economic conditions in China as well as a reduction in ongoing pricing disputes between buyers and sellers.

These manufacturing numbers arrive just weeks before the Federal Reserve is set to convene its next two-day policy meeting on March 21. In the minutes from the Fed’s last meeting in early February, officials indicated that they remain undecided on the size of the next expected hike to interest rates after lifting them throughout 2022. 

However, it is unlikely that the ISM data will sway the Fed’s thinking one way or another given that it remains in decline. Instead, upcoming data on jobs and the next numbers for the Consumer Price Index are more likely to weigh on their next move. 

"The story remains the same for the manufacturing sector," said Munoz from TDI. "I think the Fed already has its mind made up on what it wants to see before hiking rates."