In this week’s edition of “Three on Thursday,” we examine the financial health of U.S. households through the lens of the Federal Reserve’s quarterly Z.1 Financial Accounts of the United States. Economists, investors, and policymakers rely on the Z.1 to track the flow of funds, assess balance-sheet resilience, and forecast economic trends. To learn about the key developments from the Q2 report, click the link below.

Click here to view the report

The Federal Reserve cut rates by 0.25% today, citing a rising risk to the employment side of their dual mandate.  While that was no surprise, there were many questions on where the Fed would go from here, and what it would take to accelerate or slow the pace of policy adjustment. 

Starting with the Fed statement, the most notable change from July came in highlights to the weakening employment picture.  While there was no direct reference here to the 911,000 job downward revision to nonfarm payrolls that the Bureau of Labor Statistics announced last week for the twelve months ending in March, new text was added that “job gains have slowed” and “the downside risks to employment have risen.”  Inflation does still remain a concern, with a comment added that inflation has moved up since the last meeting, but there was across the board agreement from voting members that it was appropriate to resume the rate-cut process.  There was one dissent among voters, as newly appointed Fed Governor Stephen Miran would have preferred a 0.5% cut today.     

In an odd twist, the release of updated forecasts on the path of rates, inflation, employment, and GDP (the so-called “dot plots”) shows the Fed expects stronger employment but higher inflation risk moving forward. Compared to their forecasts in June, the Fed is expecting faster economic growth for this year, with no change to the outlook for inflation or the unemployment rate in 2025. But starting in 2026, the Fed now expects the unemployment rate to be 0.1% lower than previously estimated, while inflation and growth forecasts were each raised by 0.2%.  Along with these changes, the dot plots signal Fed voters now expect two more rate cuts by year end (so three cuts including today, versus an expectation of two cuts total back in June), with 2026 and 2027 forecast to see just one cut each year of 0.25%.   It’s possible that forecasters are simply anticipating that the rate cuts they are projecting will spur improvement in the labor market while also putting upward pressure on inflation, but it’s important to remember that the Fed’s track record with forecasts is less than stellar. We believe that inflation will moderate and employment continues to grow at a very modest pace. Only time will tell.

During the press conference, Chair Powell faced questions on everything from political independence to the reliability of employment data. Arguably the most important comment came when Chair Powell was asked if today’s rate cut should be viewed as an insurance policy against the risk of further deterioration in the labor market or if the dynamics for a downturn are already here.  In Chair Powell’s words, today’s move could be viewed as a “risk management cut”.  As mentioned above, the Fed has raised their GDP growth outlook for this year as well as the years ahead, and they are primarily reacting to data suggesting employment was and remains weaker than previously believed.  In response, they are shifting from a restrictive monetary policy focused on bringing down inflation, towards a neutral policy that balances inflation and employment concerns.  If employment data improves, the Fed could just as quickly stop cuts and put inflation back at the forefront.           

As ever, the path forward from here will depend on the data, but another rate cut looks likely when the Fed meets again in late October.   Two more rate cuts this year sounds about right.  If we had to put an over/under on the Fed’s projected single rate cut in 2026, we would take the over, as a slowed pace of M2 growth impacts both the inflation data and – along with immigration changes, potential moderation in tech hiring related to AI, and slower/negative government hiring following outsized growth over recent years – the employment picture.  We would love to see a productivity boom and a resurgence in broad-based business hiring, but expect some adjustment pains as the economy continues to move away from short-term growth driven by government stimulus towards a better mix of policy and spending with private markets at the helm.          

Brian S. Wesbury – Chief Economist

Robert Stein, CFA – Deputy Chief Economist

Click here for a PDF version

Implications:   New home construction closed out a disappointing Summer by dropping 8.5% in August to the lowest level since May in what continues to be a difficult environment for developers.  Looking at the big picture, homebuilders face a number of headwinds: the largest completed single-family home inventory since 2009, high home prices, restrictive government regulations, stricter immigration enforcement making it difficult to find or replace workers, and the uncertainty of tariffs and how they’ll affect building costs.  All of this has translated into building rates reminiscent of 2019—no growth in over five years.  Digging into the details of the report, the drop in August was broad-based with single-family starts falling 7.0% to the lowest level in more than a year, and multi-family starts (which have helped lift overall construction in recent months) retreating 11.7% to a three-month low.  Meanwhile, permits for new builds continue to lag, falling 3.7% in August to a 1.312 million annual rate, the slowest pace excluding the COVID shutdown months since 2019. One way homebuilders have been combatting sluggish activity is by focusing their efforts on completing projects.  That was the case in August, as new home completions jumped 8.4% to a 1.608 million annual rate and which have now outpaced starts and permits in eleven out of the last twelve months.  With strong completion activity and tepid growth in starts, the total number of homes under construction has fallen 13.3% in the last twelve months.  In the past, like in the early 1990s and mid-2000s, this type of decline was associated with a housing bust and falling home prices.  But with the brief exception of COVID, the US has consistently started too few homes almost every year since 2007.  So, while multiple headwinds may hold back housing starts, a lack of construction since the last housing bust should keep national average home prices elevated. The encouraging news is that affordability has shown some signs of improvement.  In August, the average 30-year fixed mortgage rate fell to 6.7%, the lowest level since early 2023. This downward trend has continued through the first half of September, with rates easing further to 6.4%. Looking ahead, we anticipate mortgage rates will continue to gradually decline as the Federal Reserve makes modest cuts to short-term interest rates.

Click here for a PDF version

Implications:  Industrial production came in better than expected in August, rising 0.1% with most major categories posting gains, though data from prior months were revised downward. Looking at the details, the manufacturing sector was the biggest positive contributor, with activity increasing 0.2%. However, data underneath the surface were weaker than the headline. The gain in manufacturing was entirely driven by the volatile auto sector where output jumped 2.5%. Manufacturing ex-autos (which we think of as a “core” version of industrial production) remained unchanged. Meanwhile the typical bright spots in the “core” measure were disappointing, as well.  Production in high-tech equipment, which has been a reliable tailwind recently due to investment in AI as well as the reshoring of semiconductor production, posted a decline of 0.1%.  That said, high-tech manufacturing is up 13.8% in the past year, the fastest pace of any major category.  The manufacturing of business equipment also fell 0.1% in August but is still up at a strong 7.1% annualized rate in the past six months.  Looking outside of manufacturing, the mining sector was also a source of strength in August, with activity rising 0.9%.  A faster pace of oil and gas production, metal and mineral extraction, as well as the drilling of new wells all contributed. Look for an upward trend in activity in this sector in 2025 as the Trump Administration takes a more aggressive stance with permitting.  Lastly, utilities output (which is volatile and largely dependent on weather) posted a decline of 2.0% in August. In other news this morning, the NAHB Index (a measure of homebuilder sentiment) remained at 32 in September, the lowest level since the end of 2022.  Keep in mind a reading below 50 signals a greater number of builders view conditions as poor versus good, now the seventeenth consecutive month that has been the case.

Click here for a PDF version

Implications:  Despite a cooling labor market, US consumers spent at a solid clip in August, with retail sales beating even the most optimistic forecast from any Economics group surveyed by Bloomberg and rising 0.6%, the third consecutive monthly increase.  Factoring in revisions to previous months, retail sales grew an even faster 0.8%.   Sales rose in nine out of the thirteen major categories for the month led by a 2.0% jump at nonstore retailers (think internet and mail-order).  That strength, along with gains at clothing stores (+1.0%) and sporting goods stores (+0.8%), likely reflects some seasonal purchases as students returned to school.  Meanwhile, auto sales continue to climb, up 0.5% in August and +5.6% in the past year.  “Core” sales, which exclude volatile categories such as autos, building materials, and gas stations, increased by 0.7% in August and were revised upward for previous months.  The core number is crucial for estimating GDP, because when it calculates GDP the government uses other sources for autos, building materials, and gas, not the retail report. If unchanged in September, these sales will be up at a 6.3% annual rate in Q3 compared to the Q2 average, the fastest quarterly pace since 2023.  In the past year, these sales are up 6.0%, above the 5.0% increase for overall sales.  Keep in mind, however, that a monetary policy tight enough to bring inflation down is also tight enough to bring economic growth down.  One category we will be watching closely for this is at restaurants & bars – the only glimpse we get at services in the report, which make up the bulk of consumer spending.  That category continues to whipsaw, rising 0.7% in August, after declining in two out of the three months prior.  While this report appears to differ from some other signs of a slowing economy, we remain cautious given the potential delayed effects of tighter monetary policy.  In other recent news, the Empire State Index – a measure of manufacturing sentiment in the New York region – fell to -8.7 in September from 11.9 in August.  On the trade front, import and export prices both increased 0.3% in August.  In the past year, import prices are unchanged while export prices are up 3.4%.

Click here for a PDF version

If a tree fell in the woods, but the data said it didn’t, does it really mean anything?

In spite of what appeared to be relatively good data, many polls throughout the 2024 election cycle showed more than half of all voters rated the economy as “poor.” That left the Biden/Harris team often wondering why they couldn’t get credit for what official statistics said was a robust economy.

Now it looks like we know why.  The Labor Department estimated that it’s going to need to revise down the amount of payroll growth between April 2024 and March 2025 by a total of 911,000.  This doesn’t mean payrolls outright declined during that year-long period; what it means is that contrary to prior reports of 147,000 jobs per month, jobs only grew about 71,000 per month in the year ending March 2025.

To be clear, these annual revisions are relatively small compared to total jobs (about 0.6% of the 160 million total), and we have seen revisions this large before.  But this is the third year in a row of downward revisions, which is unusual outside of dramatic events like recessions.

What all of this suggests is that the economy was much weaker last year than previously thought.   At present, the official GDP reports say the economy grew 2.0% in the year ending in March.  But reducing job growth from 147,000 per month to 71,000 could mean a noticeable downward revision to real GDP growth when that annual revision is announced by the Commerce Department in late September.

Just as important is that now, after revisions, when we look back at the year ending in March 2025, government jobs plus government-dominated jobs in healthcare and social assistance made up more than 100% of all jobs created.  As it turns out, private sector jobs outside of these areas declined.  No wonder voters weren’t happy about the economy.

More importantly, from an economists’ point of view, it clears up an economic mystery.  After surging in the first two years of COVID, the M2 measure of the money supply declined from early 2022 through late 2023, and yet economic growth appeared to be unaffected.  No recession, no major slowdown.

But what if government statisticians missed the slowdown and are just now getting around to finding it?  Moreover, what if the economic effects of the decline in M2 were temporarily masked or hidden in 2024 by a combination of (1) an unprecedented surge in immigration and (2) a reckless increase in the budget deficit?

If so, the risk of a recession in the next year or so is likely higher than most investors believe.  In the past several months, immigration policy has been turned on its head, with a sudden shift from virtually open borders to what could be an immigration flow close to “net zero.”  Meanwhile, the Congressional Budget Office is hinting that this year’s budget deficit will be smaller than last year’s relative to GDP while DOGE cuts to bureaucrat jobs are reducing government employment.

Long term, we believe a smaller government will pay dividends, leading to greater private sector growth and more prosperity.  But, in the very short-term, less stimulus could lead to some economic headwinds as workers and businesses have to adapt to the new environment.

In turn, this also means the Federal Reserve is almost certainly going to cut rates on Wednesday – we think by a quarter percentage point – and will be inclined to cut rates further in the fourth quarter, likely by another half a point total.

Some investors will see this as a reason to tilt even more toward risky assets.  But we are more concerned about the downside risk these policy measures are designed to protect us from than the measures being taken themselves. If a firetruck shows up at a house, that’s not a reason for civilians to run into the building, even if the data appear to say there is no fire. 

Brian S. Wesbury – Chief Economist

Robert Stein, CFA – Deputy Chief Economist

Click here for a PDF version

Implications:   Inflation came in above expectations in August, with the Consumer Price Index increasing 0.4%, and the year-ago comparison climbing to 2.9%.  “Core” prices, which strip out food and energy, rose a consensus expected 0.3%, while the twelve-month core comparison stood pat at 3.1%.  Looking at the details of the report, the volatile energy and food categories led overall prices higher, with energy prices rebounding 0.7%.  Notably, airline fares contributed the most to core inflation in August, with prices for the category jumping 5.9% after a 4.0% increase in July. Those are the two largest monthly increases for the airline fare since mid-2022.  In the past year, the main driver of core inflation has been housing rents, which rose 0.4% in August.  Other core categories to increase were prices for used cars and trucks (+1.0%), motor vehicle repair (+2.4%), and apparel (+0.5%).  Meanwhile, the category for medical care dropped 0.2% in August, as both prices for prescription drugs (-0.2%) and nonprescription drugs (-0.9%) declined.  In other news this morning, initial jobless claims jumped 27,000 to 263,000: the highest level since 2021. Meanwhile continuing claims remained at 1.934 million. These figures are consistent with a job market that is barely treading water in September, although the Labor Day holiday may have affected the report. Given the softening labor market and slow growth in the M2 measure of the money supply, we believe it’s time for the Fed to begin reducing short-term rates slightly in the months ahead, but cautiously. We expect the Fed to cut rates by 25 bps at the meeting next week. Yes, inflation remains above the 2% target.  But tepid economic and job growth suggests monetary policy is tight and inflation will decline in the year ahead.

Click here for a PDF version

On Tuesday, the Bureau of Labor Statistics (BLS) released the preliminary benchmark revision of payrolls for the year ending in March 2025. In this week’s “Three on Thursday,” we explore what happened and its implications for jobs. Curious about the results? Click the link below to find out more.

Click here to view the report

Implications:  Producer prices surprised to the downside in August, declining 0.1% following an unusually large increase in July.  Among the typically volatile food and energy categories, energy prices declined 0.4% in August while food prices rose 0.1%.  Excluding these categories, “core” producer prices declined 0.1% in August, matching the headline reading, although these prices are up 2.8% versus a year ago.  While tomorrow’s report on consumer prices will likely hold more weight in the Fed’s decision-making process when they meet next week, it looks virtually certain that they will re-start rate cuts that have been on hold since the start of the year.  The Fed remains concerned that tariffs will push prices higher at some point, but the data haven’t matched their expectations. In the past six months, goods prices – which are most exposed to higher import costs – are up a very modest 0.5% at an annualized rate.  Services prices are up at a 1.4% annualized rate over the same time period, suggesting the downward trend in inflation remains in place.  As we noted in prior reports, tariffs can raise prices for tariffed items, but they leave less money for consumers left over for other goods and services. They shuffle the deckchairs on the inflation ship, not how high or low the ship sits in the water.  That’s up to the money supply, which is up only 1.7% since April 2022.  We believe monetary tightness will keep inflation relatively subdued and that there is room for modest rate cuts.  In other recent news, the Bureau of Labor Statistics released initial benchmark revisions to nonfarm payrolls for the twelve months ending March 2025, estimating that payrolls during this period grew 911,000 less than previously reported.  With these revisions, it is now estimated that the US economy added around 71,000 nonfarm jobs per month during the year ending March 2025, versus a prior estimate of 147,000.  Slower job growth during this timeframe is consistent with the drop in the M2 measure of the money supply from early 2022 through late 2023 and there may be even slower job growth in the year ahead due to the lags associated with a tighter monetary policy as well as the temporary effects of slower growth in the federal budget deficit.

Click here for a PDF version

Over the past twenty years, in spite of incredible new technologies, US real GDP growth has averaged just 2.0% at an annual rate.  By contrast, in the twenty years prior to the most recent twenty – from the mid-1980s thru the mid-2000s – real GDP grew at a 3.2% annual rate.  Some slower growth is due to the aging and retirement of Boomers, but in our view, the real culprit is the expansion in the size of government.

Government spending surged in 2008 and during COVID.  At the same time the Federal Reserve held interest rates extremely low, M2 growth surged, immigration accelerated, and environmental regulation altered economic activity.  Economists in government and academia promised us this would boost growth and jobs, instead growth slowed.

But now policies are changing.  The Big Beautiful Bill avoided a tax hike in 2026 (and made current tax rates permanent), tariffs are heading higher, immigration has slowed significantly, and regulations are being reduced.  In the first half of this year, the economy grew at a 1.4% annual rate.  The Atlanta Fed GDP Now model currently projects a 3.0% growth rate in the third quarter.  If that forecast turns out to be accurate, the annualized growth rate for the first three quarters of this year would be 1.9%, in-line with the modest long-term 2.0% trend.

At the same time, Artificial Intelligence is taking off and even though estimates about how AI will impact productivity and growth are all over the map they all say it’s positive.

So, with all these cross currents, uncertainty is substantial and to say the economic data have been “quirky” lately would be an understatement.  Nonfarm payrolls were up only 22,000 in August and are up only 70,000 per month in the past seven months versus growth of 146,000 per month in the same seven months in 2024.  Trade patterns are extremely volatile, with real GDP down in Q1, but up in Q2 and Q3.

A sharp drop in immigration is likely a key factor behind slower job growth.  Meanwhile, government payrolls are down 97,000 in the past seven months, the biggest (non-Census related) seven-month drop in at least 35 years.  We view this a positive for long-term private sector growth, but also a drag on jobs in the short-term.

But even as job growth has slowed, much of the economy has been holding up quite well.  Through July, retail sales are up 4.1% versus the same period in 2024; sales of cars and light trucks have averaged a 16.3 million annual rate so far this year, versus a 15.5 million rate in the first eight months of 2024. Manufacturing output in the first seven months of this year is up 0.8% versus the same seven months in 2024.  That might not sound like much, but factory production is below where it was ten years ago, so any growth in this sector is good news.

Is some of this increase in manufacturing due to reshoring because of tariffs?  After all, that’s what tariffs are supposed to do.  But the stop-start nature of some of the tariffs, as well as uncertainty regarding whether the courts will eventually strike down the tariffs is likely an obstacle for many firms to build out this production in the US.  It’s tough to make large, long-term commitments with so much uncertainty.

The case now nearing the Supreme Court is a prime example, with the Kalshi prediction market tilting toward a Trump Administration loss.  This all has to do with questions about whether Congress has delegated authority over tariffs to the executive, or whether trade deficits, fentanyl and border security are “emergencies” which the executive must address.

But even if SCOTUS strikes down the tariffs by early next year, that’s not the last word.  President Trump would likely use other laws already on the books to try to impose tariffs, or could seek legislation to raise tariffs, possibly through budget reconciliation, which would require only a simple majority in the Senate.  In other words, uncertainty remains on this issue.

That leaves AI…clearly it changes things.  Is it like the railroad or cellphone which accelerated travel, communication and trade?  Or does it cannibalize activity in areas like search or coding?   Growth in certain tech jobs has already leveled off.  We are not Luddites and don’t expect mass unemployment from AI; but some will gain while others lose.  In the near term we do not see an economic boom from AI similar to what happened in the 1990s in the first internet boom.  Then, economic growth picked up quickly; so far, with AI, we are still waiting.  And whether growth picks up in the future is still dependent on whether or not Congress and the President can get spending under control.

Brian S. Wesbury – Chief Economist

Robert Stein, CFA – Deputy Chief Economist

Click here for a PDF version