The Institute for Supply Management's index of national factory activity dipped to 52.8 last month, the lowest reading since June 2020, when the sector was pulling out of a pandemic-induced slump. The ISM index was at 53.0 in June.
Economists polled by Reuters had forecast the index would fall to 52.0. A reading above 48.7 over a period of time generally indicates an expansion of the overall economy.
A reading above 50 indicates expansion in manufacturing, which accounts for 11.9% of the U.S. economy.
Supply bottlenecks appear to be easing. The ISM's measure of supplier deliveries dropped to 55.2 from 57.3 in June. A reading above 50% indicates slower deliveries to factories.
The better-than-expected ISM reading suggested that the economy was not in recession despite a decline in gross domestic product in the first half of the year. But businesses are sitting on excess inventories after ordering too many goods because of worries about shortages, hurting new orders.
"There are signs of new order rates softening as panelists are increasingly concerned about excessive inventories and continuing record-high lead times," said Timothy Fiore, chair of the ISM Manufacturing Business Survey Committee.
"Employment activity remained strongly positive in spite of the uncertainty with new order rates," he added.
Four of the six biggest manufacturing industries - petroleum and coal products as well as computer and electronic products, transportation equipment and machinery - reported moderate-to-strong growth last month.
However, the ISM survey's forward-looking new orders sub-index dropped to 48.0 last month from a reading of 49.2 in June. It was the second straight monthly contraction. Combined with a steady reduction in order backlogs, that suggests a further slowdown in manufacturing in the months ahead.
The cooling also reflects a shift in spending back to services from goods and the impact of rising interest rates as the Federal Reserve tackles stubbornly high inflation. The U.S. central bank last week raised its policy rate by another three-quarters of a percentage point. It has now hiked that rate by 225 basis points since March.
High inflation was also a major complaint among businesses even though overall price increases for inputs have started slowing considerably. Makers of chemical products said inflation is "slowing down business," and also noted an "overstock of raw materials due to prior supply chain issues and slowing orders."
Manufacturers of food products reported that "many customers appear to be pulling back on orders in an effort to reduce inventories." Textile mill operators said "continuing delivery and staffing issues have eaten away the bottom line."
While the survey's measure of factory employment rose to 49.9, it remained in contraction territory for a third straight month. Technology companies like Tesla have been laying off workers, but many manufacturers as recently as of June expressed difficulty finding workers.
There were 11.3 million unfilled jobs across the economy at the end of May, with nearly two job openings for every unemployed worker.