The nonmanufacturing sector, which represents more than 80% of the U.S. economy, appears to be feeling the brunt of the post-Katrina and Rita surge in energy prices and plunge in consumer confidence.

The Institute for Supply Management said Wednesday that its nonmanufacturing index plummeted to a reading of 53.3 in September from 65.0 in August. This marked the biggest one-month drop in the eight-year history of the index. Wall Street economists were expecting the index to drop to 60.

"Many members' comments expressed concern about the continuing increase in oil and gas prices as well as Hurricane Katrina, and their impact on prices and economic activity," said Ralph Kauffman, chair of ISM's nonmanufacturing business survey committee.

The services report contrasted sharply with the ISM's survey of manufacturing Monday, which showed that sector of the economy was surprisingly strong in September. The ISM manufacturing index jumped to 59.4 in September from 53.6 in August, against expectations for the index to dip to 52.0.

Economists said that while the manufacturing sector was spared because of its indirect link to the consumer, service-sector firms are feeling the brunt of plunging consumer confidence.

In addition, service-sector operations, unlike manufacturing ones, were more likely to be located in the center of cities, such as New Orleans, that were hit by the hurricanes. On that note,

Wendy's

(WEN) - Get Report

said Wednesday that same-store sales were hurt by store closings after Hurricanes Katrina and Rita, high gasoline prices and lower consumer spending levels. The restaurant-chain operator also lowered its earnings forecasts.

Finally, manufacturing firms were upbeat in part on expectations of huge rebuilding efforts in southeastern states hit by Katrina and Rita.

"While manufacturing may have gotten a boost from the hurricanes, the rest of the economy is feeling the effects of the energy price spikes," says Joel Naroff, president of Naroff Economic Advisors.

The two ISM reports, however, did share something in common: rapidly rising inflation gauges. In the manufacturing survey, the prices paid index surged from 62.5 in August to 78 in September. In the service sector index, the prices paid index jumped from 67.1 to 81.4, which was the index's highest reading since it was created in 1997.

The double blow of slowing economic growth and rising inflation pressures fueled existing concerns on Wall Street Wednesday. Stocks, which had opened in negative territory, fell further on the ISM report. They also were pressured as crude oil and natural gas prices rose after the latest government energy inventory report.

The

Dow Jones Industrial Average

was recently down 50.34 points, or 0.48%, to 10,390.77. The

S&P 500

was down 8.11 points, or 0.67%, to 206.36. The

Nasdaq Composite

was down 18.35 points, or 0.86%, to 2121.01.

In bond trading, the view seemed to be that the drop in service sector activity supported a slower overall economy, eventual easing of inflationary pressures and shortening of the

Federal Reserve's

tightening campaign. The benchmark 10-year Treasury bond was recently up 8/32 in price while its yield, which moves inversely, dropped to 4.34%.

Some Wall Street economists, like the Fed, were of the view that the post-Katrina deceleration in the service sector should be temporary. Ian Shepherdson, chief U.S. economist at High Frequency Economics, noted that service-sector firms, unlike manufacturers, deal directly with consumers.

"We're guessing that these businesses have been alarmed by the possible implications of the post-Katrina drop in consumer confidence and the surge in gas prices; both appear to point to a period of softer consumption," he said.

However, Shepherdson believes that consumer confidence appears to have bottomed out according to the latest weekly polls by

ABC/Washington Post

. "We therefore expect the October nonmanufacturing ISM to rebound somewhat."

How much of a rebound will be key for markets, which are now trying to determine what impact the double-blow of slowing economic activity and rising inflation will have on profits. A number of companies, including

Clorox

(CLX) - Get Report

and

Goodyear

(GT) - Get Report

on Tuesday, already have lowered their earnings guidance due to rising energy and commodity costs.

In this consumer-driven economy, a bigger concern remains whether consumers will be able to absorb much-higher energy prices without flinching. "Unless energy costs drop soon, and that does not look to be the case, the holiday shopping season could be at risk," says NEA's Naroff. (Thursday's same-store sales data for September could provide an early indication of just how much is at risk.)

An extended slowdown in economic activity, he warns, could be accompanied by rising inflation, which would fuel the Fed's determination to keep raising rates. "Neither stock nor bond investors should be happy about that prospect," Naroff says.

In keeping with TSC's editorial policy, Godt doesn't own or short individual stocks. He also doesn't invest in hedge funds or other private investment partnerships. He appreciates your feedback;

click here

to send him an email.