The U.S. manufacturing sector shrank at its fastest rate since the COVID-19 pandemic after new orders dropped and production slowed as more consumers shifted their spending back into services.

The Institute for Supply Management (ISM) on Wednesday released its monthly PMI survey, which showed activity falling to 46.3 in March, down from 47.7 in February and the lowest since April 2020. A reading below 50 indicates a fall in manufacturing activity.

The decline in manufacturing has been driven by a slump in new orders and exports of goods. Though the price of raw materials dipped from where it was in February, overall output decreased as more businesses loosened their efforts to hold onto workers and as manufacturers shifted to extend production later into 2023, according to the survey.

Manufacturing’s woes have been worsened by the Federal Reserve raising interest rates at its fastest pace in decades. The Fed has recently slowed its rate hikes, but has left open the possibility of more increases. This has led manufacturers to pare back on future investments as borrowing becomes more expensive.

Jay Bryson, a managing director and chief economist at Wells Fargo, said that it was unclear why manufacturing in March slipped further than expected but suggested it was part of a longer shift in consumer spending back towards services over goods.

“There’s been a rotation away from spending on goods towards services,” said Bryson. “In general, manufacturing has weakened over the last couple of months.”

Spending on services rose by $25.8 billion in February, compared to a $2 billion increase in spending on goods, the Commerce Department reported in April. At the same time, the manufacturing sector has been weighed down by an increasingly pessimistic outlook as more managers express demand for it to fall in the near future.

This was reflected in the ISM survey’s sub-index for new orders, which fell to 44.3 from 47 in February. Five of the six largest manufacturing sectors have declined since then, with the only gains seen among manufacturers of energy products. The sub-index for new exports was cushioned somewhat by continued demand from China and Europe but weakened from 49.9 to 47.6 in March.

In a reversal from February, businesses have signaled a greater willingness to reduce their worker counts. According to the ISM sub-index for employment, which dropped to 46.9 from 49.1, manufacturers had lower expectations for what they previously anticipated would be a stronger second half to 2023. 

A pair of recent bank failures and the Federal Reserve’s continuing to raise interest rates in March have only added to the negative outlook for the manufacturing sector. Economists said that it remains too early to determine the impact of recent banking problems, but some survey respondents reported that they were closely monitoring the banking situation for signs of a spillover into manufacturing.

Steve Ricchiuto, chief economist for the Americas at Mizuho Securities USA, cautioned against reading too much into the March report. Pointing to the survey’s focus on manufacturers’ sentiments, Ricchiuto said that the report’s picture of the sector’s health may be distorted by fears about recent developments. Instead, he noted that the steady level of weekly initial unemployment claims in recent months and still robust commodity prices suggest the sector is being guided by prevailing sentiments rather than data. 

“This is how markets behave,” said Ricchiuto. “They look for what supports their narrative, and for a time, they run with that narrative, and this is what they’re doing.”