Implications:  Consumer spending power has been rising at a blazing pace to start 2025, with personal income up 0.8% in April following a strong 0.7% increase in March, 0.8% in February, and 0.6% in January.  Unfortunately, the gains have been primarily driven by government transfers.  In January, this was due to cost-of-living adjustments to Social Security benefits; in February it was premium tax credits for health insurance purchased through the Health Insurance Marketplace (Obamacare).  April’s income gains were once again led by government transfer payments, most notably payments related to the Social Security Fairness Act – one of the last items signed into law by the outgoing Biden administration – which increased benefits to public sector workers not typically covered by Social Security. That said, private sector wages and salaries, up 0.5% in April, have also been rising at a healthy pace.  In the past year, private sector wages and salaries are up 4.5%, which is keeping pace with inflation and then some.  For comparison, public sector pay has risen 5.3% and government benefit payments to individuals are up 11.1% in the past year.  We don’t think the growth in government pay – or massive government deficit spending – is either sustainable or good for the US economy, which is why we have been hoping policy changes in DC represent a shift in thinking on the growth of government. Long term, it’s the growth in private-sector earnings that sustain the economy.  Personal consumption rose a modest 0.2% in April as spending on services increased 0.4% while goods spending declined 0.1%.  Within services, the largest increases came in housing & utilities services, health care, and food services & accommodations.  Within goods, a rise in spending on energy was more than offset by pullbacks in spending in most major goods categories.  On the inflation front, PCE prices rose 0.1% in April and are up 2.1% in the past year, matching the lowest twelve-month change going back to early 2021. “Core” prices (which exclude food and energy) rose 0.1% in April and are up 2.5% versus a year ago, which also represents the lowest year-ago increase seen since early 2021. Some analysts claim official inflation figures continue to run above the Fed’s 2.0% target because of rents, but the “SuperCore” version of PCE prices, which excludes all goods, energy services, and rents, is up 3.0% in the past year, worse than headline inflation.  The Fed is unlikely to move at the June meeting, as it continues to fret about potential inflationary impacts from tariffs and increased uncertainty surrounding policy out of Washington, but we believe the Fed will resume rate cuts in the later part of 2025.  In other news this morning, the advance report on trade and inventories signaled a huge reduction in the trade deficit in April, which should boost second quarter Real GDP growth, offsetting the slight drop in Real GDP in Q1.  In recent news on the housing front, pending home sales, which are contracts on existing homes, fell 6.3% in April following a 5.5% increase in March, suggesting existing home sales (counted at closing) will tread water in May.

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In this week’s Three on Thursday, we take a closer look at the evolving role of tariffs in U.S. economic policy. In the latest development, a U.S. trade court ruled yesterday that President Trump did not have the authority to impose many of these tariffs. However, the ruling has been temporarily put on hold as the case moves through the appeals process. Click the link below to see where things stand in this highly fluid situation.

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Implications:  Hold off on GDP for a moment.  The most important data in this morning’s report was on economy-wide corporate profits, which declined 2.9% in the first quarter and fell 3.4% excluding the profits/losses of the Federal Reserve.  Excluding the Fed, profits are still up 3.6% from a year ago, but that is the slowest growth for any four-quarter period since 2020.  Leading the decline in Q1 were profits from domestic non-financial industries, which fell 3.5%.  Profits from the rest of the world fell as well.  Plugging in profits into our Capitalized Profits Model suggests stocks remain overvalued. Real GDP for the first quarter was revised slightly higher to a -0.2% annualized rate, as upward revisions to inventories, government spending, and business investment more than offset downward revisions to consumer spending (especially services), home building, and net exports. For a clearer picture of underlying growth, we focus on “core” GDP—consumer spending, business fixed investment, and residential construction—excluding more volatile components like inventories, government outlays, and trade. Core GDP was revised down to a still-solid 2.5% annual rate from the initial 3.0%, though still marks the slowest pace in nearly two years. The downgrade was driven largely by weaker consumer spending, now estimated to have grown just 1.2%, down from 1.8%—also the slowest in almost two years. On the inflation front, the Fed’s fight isn’t over: the GDP price index held steady at a 3.7% annualized rate in Q1, with prices up 2.6% from a year ago, slightly higher than the 2.4% year-over-year increase in Q1 2024. In other news this morning, initial jobless claims rose by 14,000 last week to 240,000, while continuing claims rose 26,000 to 1.919 million.  These figures are consistent with continued job growth in May, but at a slower pace than last year. In other recent news, the M2 measure of the money supply hit a new record high growing 0.7% in April and is up 4.4% from a year ago.  This remains below the 6% growth that has been normal over the past few decades, and in combination with recent inflation reports, we think the Fed has room for modest rate cuts later this year. Finally, on the manufacturing front, the Richmond Fed index, a measure of mid-Atlantic factory activity, increased to -9 in May from a reading of -13 in April.

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Implications:  New orders for durable goods plummeted in April, but beneath the headline lay a much more subdued picture.  The 6.3% decline in new orders was almost entirely due to the very volatile category of commercial aircraft, which came back down to earth after surging in March.  Tariffs certainly played a role here, as airlines front-ran orders before anticipated tariff increases, while President Trump’s recent tour through the Middle East resulted in the announcement of more than 200 Boeing aircraft ordered (so expect major revisions with next month’s report).  We anticipate these numbers to slow (and cancellations to increase) in the months ahead as companies and countries navigate the ever-shifting trade environment.  Excluding the transportation sector, orders for durable goods rose 0.2% in April.  Orders rose for computers & electronic products (+1.0%), machinery (+0.8%), and fabricated metal products (+0.8%), but were partially offset by declines in orders for electrical equipment (-0.2%), and primary metals (-0.1%).  The most important number in the release, core shipments – a key input for business investment in the calculation of GDP – declined 0.1% in April.  If unchanged in May and June, these shipments would be up at a 1.8% annualized rate in Q2 versus the Q1 average.  But, adjusting for inflation, little growth will be reported, and while core shipments fell at a modest pace in April, orders for these items declined a more notable 1.3% and are down at a 6.1% annualized rate in the past three months, signaling deliveries will be impacted in the future.  The current environment in Washington remains uncertain, and we expect volatility in the data to be the rule rather than the exception for the foreseeable future, as businesses navigate the new policy environment and how it may change the outlook for investment and growth.  In turn, the Federal Reserve must navigate what these changes mean for the path of inflation.  While we don’t expect any movement from the Fed at the meeting in June, we do believe that cuts are on the table for later in the year as economic weaknesses brings the employment side of the Fed’s mandate into more central focus.  In other news this morning, home prices declined in March but are up moderately versus a year ago.  The national Case-Shiller index declined 0.3% in March but is up 3.4% from a year ago; the FHFA index declined 0.1% in March but is up 3.8% from a year ago.  The decline in both indexes in March was the first time that’s happened since 2022.  Look for modest gains in national average home prices in the year ahead.

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Moody’s finally downgraded US government debt on May 16th to Aa1, its second highest rating.  With the US $36 trillion (and rising) in debt, it’s not hard to see why. But Moody’s was late to the party with S&P and Fitch (the other two major ratings agencies) having done so long ago.

The financial media went berserk, but long-term bond yields have not exactly soared.  The 10-year Treasury yield closed at 4.43% the night before the downgrade and 4.51% this past Friday, eight days later.  The 30-year Treasury yield moved up more but, again, didn’t skyrocket, closing at 4.89% on the eve before the downgrade and 5.04% as of last Friday.

What has received more attention is the gap between the yield on the 30-year and the 10-year, which has grown to 50+ basis points, noticeably higher than the 20 basis points it averaged in 2024.  However, the yield gap averaged 44 bps in the year prior to COVID, so not much change.

It's hard to separate the impact of all the moving parts affecting the bond market.  For example, Federal Reserve officials have made it clear that near-term rate cuts are, from their perspective, not warranted.  So, was it the downgrade or the Fed that put pressure on the market?

S&P downgraded US debt back in 2011 and Fitch in 2023, with no calamity as a result.  S&P’s downgrade came in the Obama Administration, Fitch’s during Biden/Harris.

Like then, the downgrade is being used to bash politicians, this time the Trump Administration and Republicans in Congress for moving ahead with efforts to extend the tax cuts originally enacted back in 2017.  Moody’s criticizes the extension as being fiscally irresponsible.  Wider deficits, according to the analysts, lead to higher interest rates on higher debt and a greater interest burden for the government to finance, leading to even bigger deficits, and so on and so forth.

The problem with this theory, though, is that the policies being pursued are not going to lift budget deficits beyond the policies that are already in place.  In other words, why wait until now to downgrade debt based on current policies?

Spending soared after COVID, even with the economy opening up and unemployment at 4% or less.  It was the spending that created $2 trillion deficits and the Biden Administration never talked about tax hikes.

The Big Beautiful Bill includes some spending cuts.  According to the Tax Foundation, a non-partisan think tank, the bill recently passed by the House will reduce the deficit by roughly $1.9 trillion in the next ten years compared to a simple alternative of passing a bill that merely extended the 2017 tax cuts for the next ten years.  That’s because the latest bill includes both higher expected revenues as well as some reforms to entitlements, like Medicaid.

In addition, tariffs should generate some extra receipts and the Trump Administration has proposed steep cuts to non-defense discretionary spending for Fiscal Year 2026 (starting October 1), calling for 32% less spending on these programs versus what the Congressional Budget Office assumed back in January.  If those cuts happen, the “baseline” for future spending could be a few trillion lower in the next decade.

None of this is to suggest that the US fiscal position is good; it’s certainly not.  In spite of record tax revenue, spending is so high that budget surpluses are nowhere in sight.  Back in 2007, the budget deficit was only about 6% of federal spending.  In other words, it wouldn’t have taken many spending cuts to get to a balanced budget.

But by 2019 (the year before COVID), the budget deficit was 22% of federal spending.  Now it’s 27% of federal spending.  Imagine cutting your household budget by 27%!

The good news is we don’t have to run surpluses to make our debt position manageable.  At a minimum we want overall debt to grow no faster than nominal GDP.

The more we reduce the deficit by cutting spending, the more resources stay in the private sector, setting off a virtuous cycle of more growth, more revenue, and smaller deficits. It happened under President Clinton.  Now that the Senate has the bill, can we do it again?

Brian S. Wesbury – Chief Economist

Robert Stein, CFA – Deputy Chief Economist

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Implications:  New home sales surprised to the upside in April, easily beating consensus expectations to post the largest monthly gain in nearly two years.  Looking at the big picture, buyers purchased 743,000 homes at an annual rate. While that may be well below the highs of the pandemic, sales are at the fastest pace since 2022 and are now modestly above pre-pandemic levels.  Looking at the details, gains were broad based in April with only the Northeast posting a decline. Though we expect a modest upward trend in sales in 2025, the housing market continues to face challenges. The biggest (and most obvious) is financing costs. The Fed has recently paused their rate cuts, meaning the housing market is on its own for the time being. That said, April’s gain happened despite rising interest rates, with the average 30-yr fixed mortgage back near 7%. One piece of good news for potential buyers is that median sales prices are down 2.0% in the past year, and down 11.5% from the peak in October 2022.  The Census Bureau reports that from Q3 2022 to Q1 2025 (the most recent data available) the median square footage for new single-family homes built fell 5.6%. So, while part of the drop in median prices is due to smaller/lower-cost homes, there has also been a drop in the price per square foot.  This may be the result of developers offering incentives to buyers in order to move inventory. Supply has also put more downward pressure on median prices for new homes than existing homes.  The supply of completed single-family homes is up over 270% versus the bottom in 2022. This contrasts with the market for existing homes which continues to struggle with an inventory problem, often due to the difficulty of convincing current homeowners to give up the low fixed-rate mortgages they locked-in during the pandemic. While the future cost of financing remains a question, lower priced options and an abundance of inventories will help fuel new home sales in 2025.  Finally, in recent manufacturing news, the Kansas City Fed Manufacturing Index, a measure of factory sentiment in that region, rose to a still weak reading of -3 in May from -4 in April.

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In this week’s “Three on Thursday,” we explore the current state of indebtedness and financial health of U.S. households in the first quarter of 2025. Curious about the latest trends? Click the link below to get a clearer picture of where things stood in the first quarter.

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Implications:  Existing home sales were essentially unchanged in April, remaining sluggish after the biggest monthly decline since 2022. Sales activity has been characterized by fits and starts over the past couple years, with any positive upward trend eventually running into a ceiling of around 4.300 million.  Big picture, sales are still well below the roughly 5.250 million annual pace that existed pre-COVID, let alone the 6.500 million pace during COVID.  Affordability remains the biggest headwind to sales, and unfortunately 30-year mortgage rates have begun to climb again recently and are back near 7%.  Meanwhile, the median price of an existing home is up 1.8% from a year ago.  Speaking of price, it looks like the housing market has bifurcated.  While the sales of homes worth $250,000 and above are up in the past year (and rising faster the more expensive the property), sales for homes below this threshold have continued to fall.  On a positive note this demonstrates that, at least at the higher end of the market, both buyers and sellers are beginning to adjust to the new reality of higher rates.  However, it also suggests that at the lower end of the price spectrum inflation has priced many Americans out of the existing home market.  Existing home sales also face significant competition from new homes, where in many cases developers are buying down mortgage rates to compete and move inventory.  (When interest rates are higher, firms, including homebuilders, forego more potential earnings by holding onto inventories.)  Finally, many existing homeowners remain reluctant to sell due to a “mortgage lock-in” phenomenon, after buying or refinancing at much lower rates before 2022.  This remains a major impediment to activity by limiting future existing sales (and inventories).  However, there are signs of progress with inventories rising 20.8% in the past year.  That has helped push the months’ supply of homes (how long it would take to sell existing inventory at the current very slow sales pace) to 4.4 in April, a considerable improvement versus the past few years, but still below the benchmark of 5.0 that the National Association of Realtors uses to denote a normal market.   A tight inventory of existing homes means that while the pace of sales looks like 2008, we aren’t seeing that translate to a big decline in prices.  In other news this morning, initial jobless claims fell by 2,000 last week to 227,000, while continuing claims rose 36,000 to 1.903 million.  These figures are consistent with continued job growth in May, but at a slower pace than last year.

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Milton Friedman, Art Laffer and other market-believing economists had their long day in the sun during the 1980s and 1990s.  Tax rates fell and government spending declined relative to GDP.  But – ironically, in the long run, and long after he passed away – John Maynard Keynes got his revenge.

Whereas free-marketeers believed markets were self-correcting, Keynes thought market failures required government intervention.  As a result, during the last two crises (the 2008-09 mark-to-market panic and COVID), government spending and easy money have been on a one-way elevator.  Non-defense government spending shot from less than 15% of GDP in 2000 to more than 20% today.  The M2 money supply has tripled since 2007, with the introduction of Quantitative Easing as a new way for the Federal Reserve to manage the economy rather than wait for the market itself to heal the economy.

The US has run roughly annual budget deficits of about 6.5% of GDP in the past two years and looks to be on pace to do it again in FY2025, even with DOGE and an administration budget proposal that promises to cut spending at some point.

There are at least a couple reasons Keynes won the day.  First, political leaders in Washington, DC are naturally inclined to think more government spending and looser monetary policy will boost the economy, as those policies let them hand out gifts to voters and put them in a position of prominence.  In a nutshell, you get to play Santa Claus without having to put on a red suit.

Second, Keynesian theory promises government-spending multipliers, where every dollar of government spending creates more than a dollar of GDP growth!  How do they promise to deliver this magic?  By taxing people with a higher marginal propensity to save and giving to those with a higher marginal propensity to spend.

Keynesians think that consumption drives growth.  After all, consumer spending makes up almost 70% of GDP…so if you can reduce savings and boost consumption, on the chalkboard you can actually boost economic activity.

But, no matter what the chalkboard says, it hasn’t worked.  In the past 20 years, real GDP has grown just 2.0% per year in spite of incredibly productive new technologies (smartphones, high speed internet, apps, the cloud, AI,…etc.).  And don’t forget government spending has soared (from $3 trillion per year in 2007 to $7 trillion per year now), and the Fed also got super easy, boosting money and holding interest rates near zero for nine of the past 17 years.  In spite of all of this, economic growth has stagnated, houses are unaffordable, and the percentage of Americans on food stamps has more than doubled since 2001.

At 2.0% real GDP growth, the US is growing half as fast as it did in the 20 years following WWII.  In other words, Keynesianism did not fulfill its promise.  The more money we push, the less growth we get.  It’s not that hard to understand.  It may seem like there is money everywhere, because the Fed has flooded the financial system, but saving rates are actually way down…which is what happens when you tax savers and redistribute it to spenders.

The “real” (inflation-adjusted) consumption of goods is up 62% since 2008, while value-added manufacturing is only up 14%.  We may be producing more than ever in the US, but consumption has outstripped our production by a massive amount.  The result: huge trade deficits, less real economic growth, less savings, and irresponsible budget deficits.

Put it all together and we have reached peak Keynesianism.  It doesn’t work.  Unfortunately, the only way out is to cut the size of government by a significant amount.  We say unfortunately because Congress, led by either major political party, hasn’t found a way to do that. In fact, even GOP members of Congress are pushing back against reducing Green New Deal spending or any cuts to Medicaid.

Sure, voters like the spending, and government has found its way into every nook and cranny of our lives.  We keep doing the same thing over and over again and we keep expecting different results.  But they won’t ever come.  The bigger the government gets, the less we get in return.  It’s past time to remember Milton Friedman and market-believing economic models.

In spite of the success of the US economy in the 1980s and 1990s, when we cut tax rates, spending slowed and regulation was reduced, Government keeps roaring back.

Brian S. Wesbury – Chief Economist

Robert Stein, CFA – Deputy Chief Economist

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Implications:  Housing starts rebounded modestly in April after a steep drop in March but the details of the report were not favorable.  Looking at the big picture, homebuilding seems to be stuck in low gear, hovering around 2019 levels, as builders struggle with the most single-family inventory since 2009 along with high home prices and relatively high mortgage rates. Now, builders must also contend with the uncertainty of new tariffs and how they’ll affect their building costs. That struggle can be seen in the data, as single-family starts declined 2.1% to a nine-month low, and permits fell 5.1% to the lowest level in nearly two years.  April’s gain was entirely due to a 10.7% jump in the volatile multi-unit category.  In the past year, multi-family starts are up 30.7% while single-family starts are down 12.0%.  It appears that part of the reason why homebuilding has lagged is due to builders focusing on completing projects.  Home completions declined 5.9% in April but have been running hot since last year.  The 1.458 million completion rate in April outpaced starts and is the only month below a 1.5 million pace (our estimation of annual homes needed to keep up with population growth and scrappage) in the last twelve months.  With strong completion activity and tepid growth in starts, the total number of homes under construction continues to fall, down 14.3% in the past year.  That type of decline is usually associated with a housing bust, but we don’t see that happening.  With the brief exception of COVID, the US has consistently started too few homes almost every year since 2007.  As a result of the shortage of homes, we think housing is far from a bubble and expect housing prices to continue moderately higher in 2025 in spite of some broader economic headwinds.  In other recent housing news, the NAHB Housing Index (a measure of homebuilder sentiment) declined sharply to 34 in May from 40 in April.  Keep in mind a reading below 50 signals a greater number of builders view conditions as poor versus good.  On the trade front, import and export prices both rose 0.1% in April.  In the past year, import prices are up 0.1% while export prices are up 2.0%.

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