June 5 (Reuters) - The U.S. services sector snapped back into growth mode in May after a short-lived contraction in the prior month, with a measure of business activity improving by the most in three years, according to a survey published on Wednesday that may buttress the Federal Reserve's wariness of a shift to interest rate cuts.
At the same time, a gauge of hiring among private employers showed firms last month added the fewest jobs since January and small businesses shed jobs for the first time in six months, fresh signs that a tight labor market is easing back into balance.
Together, the reports from the Institute of Supply Management and payrolls processor ADP paint a mixed picture of an economy that by and large continues to withstand the hefty rate increases imposed by the Fed, although evidence is building that growth may be ebbing.
While that may the case - overall economic output in the first quarter grew at the slowest rate in nearly two years and data so far in the current quarter on balance has been softer than expected - they are unlikely on their own to be sufficient to turn Fed officials any time soon from their central focus on containing stickier-than-anticipated inflation.
ISM said its non-manufacturing purchasing managers index rose to 53.8 last month from 49.4 in April. The reading in May, the highest since last August, topped the estimates of the 59 economists in a Reuters poll that had pegged the median expectation at 50.8, just above the 50 level that separates growth from contraction.
The report's business activity index shot up 10.3 points, the largest rise since March 2021 and vaulting it to 61.2, the highest level since November 2022.
New orders growth reaccelerated after easing in the prior two months and a measure of services input costs eased. Employment, while improved from April's four-month low, remained in contraction territory at 47.1.
Thomas Simons, U.S. economist at Jefferies, said the services sector rebound from April's contraction "is encouraging as it shows a broad base of improvement across industries, but the comments from respondents highlighted in the ISM's press release are far more subdued and cautious."
The stronger-than-expected services reading stood in contrast to the ISM report on the manufacturing sector that was released on Monday. It showed factory activity contracted for the second straight month in May.
Indeed, incoming data over the last month has generally failed to meet economists' projections, adding to evidence that the Fed's interest rate increases - the U.S. central bank has raised its policy rate by 525 basis points since March 2022 - are finally weighing on an economy that has proven stubbornly resilient.
But with services accounting for the vast majority of U.S. economic output, the upside surprise may reinforce a hesitance to shift toward rate cuts among Fed policymakers who have been rattled by stiffer-than-expected inflation so far this year.
The Fed is expected to leave rates unchanged at its policy meeting next week. The central bank, however, will release updated projections from officials for growth, unemployment, inflation and the appropriate policy setting over various time horizons.
When those projections were last updated in March, the median expectation among policymakers was for three quarter-percentage-point rate cuts by the end of this year. That is certainly no longer the case, and the debate among investors now centers on whether the Fed will deliver two rate cuts or just one this year.
PRIVATE PAYROLLS SOFTENING
ADP's monthly employment report showed private payrolls increased by 152,000 jobs last month - the fewest since January and well below the average of 194,000 over the past year - after rising by a downwardly revised 188,000 in April. Economists polled by Reuters had forecast private employment would increase by 175,000 jobs last month.
Gains were led by the largest employers, with those having payrolls of 500 or more workers adding 98,000 people, about the same as the month before. Mid-sized companies employing between 50 and 499 workers added 79,000 jobs versus 59,000 in April.
Growth was concentrated in the services sector, led by trade, transportation and utilities, followed by education and health services and financial services. Leisure and hospitality companies added 12,000 jobs, the fewest since November.
Meanwhile, firms employing fewer than 50 workers cut 10,000 jobs, the first reductions in that sector since November, and manufacturers shed 20,000 jobs, the most since July.
The report reinforced other data showing the job market is coming into better balance.
On Tuesday, the Labor Department reported job openings fell in April to the fewest in more than three years and the ratio of vacancies to the number of unemployed persons had returned to levels seen prior to the COVID-19 pandemic outbreak in early 2020.
The ADP report, jointly developed with the Stanford Digital Economy Lab, also precedes the release on Friday of the Bureau of Labor Statistics' nonfarm payrolls report for May.
Economists polled by Reuters expect that report to show a gain of 170,000 private-sector jobs last month, little changed from April's 167,000, while total payroll growth is estimated at 185,000 versus 175,000 in April. The unemployment rate and yearly wage growth are both seen holding steady at 3.9%.
ADP reported wage growth moderated for job changers for the second consecutive month to 7.8% on a year-over-year basis, and pay increases for those remaining in their current job was unchanged at 5%. The education and health services and leisure and hospitality industries saw above-average increases for job stayers at 5.5%.
Fed officials are keeping close tabs on wage growth because services inflation, which has proven more difficult to tame in the central bank's drive to return overall inflation to its 2% target, is influenced more heavily by firms' wage costs.
Reporting by Dan Burns; Editing by Chizu Nomiyama and Paul Simao
