The government officially shut down yesterday as Congress failed to pass—and the President failed to sign—appropriations bills (or a stopgap “continuing resolution”) to fund government operations for the start of the new fiscal year on October 1st. Headlines often frame shutdowns as economic calamities in the making, but history suggests otherwise.  For more insights, click the link below.

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Implications:  Manufacturing activity remained soft in September but did not contract as rapidly as in August, with the index narrowly beating expectations and rising to 49.1. This makes seven consecutive months that the ISM Manufacturing index has been below 50, continuing a pattern that stretched all of 2023 and 2024.  While many believed the downturn was over when the index briefly rose above 50 in January and February, the subsequent seven months of weak readings warrant caution for the industry.  Looking at the details, just five of the eighteen major manufacturing categories reported growth in September, while more than double (eleven) reported contraction.   Unfortunately, the new orders index – which broke into expansion territory last month for the first time since January – contracted in September, falling to 48.9.  Order books were weak heading into this year; now, survey comments blame tariff uncertainty for the weakness, as many customer orders have been placed on pause until stability returns.  In addition, survey comments also report that companies are largely shouldering the added costs where tariffs have been put in place, as customers are unwilling to pay the higher prices and simply choosing not to buy.  This has caused companies to look for ways to reduce overhead, most notably through their hiring efforts.  Though the employment index rose to 45.3, it remains firmly in contraction territory, with only one major manufacturing category (Nonmetallic Mineral Products) reporting an increase in employment in September versus fourteen reporting a decrease.  Despite the stagnation in manufacturing, inflation pressures remain.  The prices index declined to 61.9 – high by historical standards – although below the recent peak of 69.7 in June, and well below the levels during the post-COVID inflation surge.  In other news this morning, ADP’s measure of private payrolls declined 32,000 in September versus a consensus expected increase of 51,000, the third decline in the past four months. However, there are often large gaps between the initial ADP report and the official report from the Labor Department, so we are estimating Friday’s official report will show a nonfarm payroll gain of 80,000 with the unemployment rate remaining at 4.3%.  On the housing front, pending home sales, which are contracts on existing homes, increased 4.0% in August, suggesting a gain in existing home sales in September.  Declining prices might be part of the reason for any pickup in sales, with both the FHFA and Case-Shiller indexes down 0.1% in July.  That’s the fourth straight monthly decline for the FHFA and fifth straight for the Case-Shiller.  Compared to a year ago, FHFA prices are up 2.3% while Case-Shiller prices are up 1.7%, both less than overall inflation.

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Economic data are all over the place.  GDP keeps growing in spite of signs of weakness in the labor market.  Tariff policy is volatile, immigration has slowed, monetary policy tightened in 2023-24, with the M2 measure of money declining and “real” short-term interest rates consistently higher than at any time since 2010.

Yes, M2 grew 4.8% in the past year, but this is slower than the pre-COVID trend of about 6.0%.  And by virtually any valuation metric (price to earnings, price to sales, and our capitalized profits model) the stock market is expensive.  Yet, it keeps moving higher, with investors showing no sign of worrying about anything.

Interestingly, even with a government shutdown looming, markets don’t seem to be worried at all in spite of talking heads and analysts warning this could cause a recession.

But there is no evidence of a link between shutdowns and recessions.  In the past thirty years the government has been shut for a grand total of 80 days.  Do you know how much of those 80 days we were in recession?  Zero.  Zilcho.  Nada.

In other words, the US economy has been less likely to be in recession when the government has been shut than when it’s open.   In fact, the closest a recession followed these shutdowns was fourteen months after the 2018-19 shutdown, and that recession was due to COVID.

None of this is to say that a recession couldn’t possibly follow on the heels of a government shutdown; it could happen.  But if we get a recession, it’s going to be due to other factors like tighter money and volatile tariffs, not the shutdown.

Nor is a shutdown going to lead to some sort of emergency.  The Treasury Department would still receive revenue and entitlement payments would still go out for Social Security, Medicare, and Medicaid.  Treasury bondholders would get paid in full, both principal and interest.  The military, border control, weather service, FAA, and the Post Office, among other operations, would still continue.

What would make this shutdown different is the posture of the Trump Administration.  Normally, “essential” federal employees continue to work and “non-essential” employees stay home.  When the shutdown ends, everyone gets back pay.

But this time the president is playing hardball.  The Administration is telling agencies and departments to make lists of non-essential workers who can be permanently let go, which means that after the shutdown, many of these workers would have no job to go back to.  Democrats are being forced to make a choice between a reduction in government workers and using the budget battles and potential shutdown to boost spending.

In other words, we may be approaching a watershed moment for the direction of federal spending, or at least the portion of spending subject to annual appropriations.

Government jobs have already declined, the Supreme Court just backed cuts to foreign aid and the looming shutdown battle seems poised to continue this process.  The US government has been way too big for way too long, reducing freedom and stifling long term economic growth.

We see reason for optimism here.  Shrinking the government boosts our long-term growth potential.  That’s exceedingly good…but it also seems clear that markets have priced in lots of good news.  Stocks are priced for perfection and while we always hope things turn out perfectly, they would have to turn out better than perfect to keep the market moving.

Brian S. Wesbury – Chief Economist

Robert Stein, CFA – Deputy Chief Economist

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Housing in America is becoming increasingly out of reach. Home prices have surged far faster than household incomes, mortgage rates remain stuck in the mid-6% range, and the ongoing costs of ownership keep rising. In this week’s “Three on Thursday” we highlight three key metrics of housing affordability—and the picture isn’t pretty. For a closer look, click the link below.

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Implications:  Existing home sales remained essentially unchanged in August, with activity continuing to trudge along at a disappointing pace. The August sales pace of 4.000 million is near the lowest since the aftermath of the Great Financial Crisis, and well below the roughly 5.250 million annual pace that existed pre-COVID (let alone the 6.500 million pace during COVID).  That said, affordability has been improving in several notable ways. First, 30-year mortgage rates have been trending lower since May and now sit around 6.3%.  Notably, this is the lowest rate since 2023 and with the Federal Reserve restarting rate cuts last week, buyers have reason for further optimism. Meanwhile, the median price of an existing home is nearly unchanged from a year ago. It looks like the inventory of existing homes rising 11.7% in the past year has helped put a lid on prices as more options become available for buyers.  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 4.6 in August, a considerable improvement versus the past few years, and approaching the benchmark of 5.0 that the National Association of Realtors uses to denote a normal market. One last positive to note is that aggregate wage growth (hourly earnings plus hours worked) has begun to consistently outpace median home prices over the past year for the first time since 2023, which improves affordability. That said, some challenges remain. 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 an impediment to activity by limiting future existing sales (and inventories).  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). Despite these cross currents, underlying fundamentals have improved recently, which should contribute to a modest rebound in sales.

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Implications:  The final reading for real GDP growth in Q2 showed the economy on firmer footing than initially thought, with growth revised up to a 3.8% annual rate. More importantly, the details improved: stronger consumer spending (services), business investment (equipment, software, and structures), and government purchases more than offset weaker readings on inventories, trade, and housing.  For a better gauge of sustainable growth, we look at “core” GDP—consumer spending, business fixed investment, and home building—while excluding the more volatile categories like government, inventories, and trade.  Core GDP grew at a 2.9% annual rate in Q2, far above the prior 1.9% estimate. The Bureau of Economic Analysis also released its annual revisions.  From 2019–2024, average real GDP growth held at 2.4%, unchanged from prior estimates—a non-event. More notable was corporate profits: the second look at Q2 profits showed growth of just 0.2% from Q1 (vs. +1.7% previously) and 3.6% year-over-year. Excluding the Fed—whose large losses drag on the totals—corporate profits rose 0.6% in Q2 and are up only 2.5% year-over-year, the second slowest four-quarter pace since 2020. Based on pre-tax profits, our Capitalized Profits Model continues to signal that equities remain overvalued. As for inflation, GDP inflation was revised slightly higher to a 2.1% annualized rate in Q2, and GDP prices have risen 2.5% over the past year. Meanwhile, nominal GDP (real growth plus inflation) increased at a 6.0% annual rate in Q2 and is up 4.6% year-over-year. All in all a very solid quarter for the economy.

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Implications:  New orders for durable goods rose 2.9% in August, but the details are a bit softer than the headline number would suggest.  The rise in new orders was largely due to the very volatile categories of commercial and defense aircraft, where August orders rose 21.6% and 50.1%, respectively.  These wild swings are why ex-transportation orders provide a much better read on the health of activity and those were more mixed in August.  The 0.4% rise in non-transportation orders was led by machinery (+1.3%), fabricated metal products (+0.7%), and primary metals (+0.1%), while electrical equipment (-0.2%) and computers & electronic products (-0.1%) declined.  The most important number in today’s release, core shipments – a key input for business investment in the calculation of GDP – fell 0.3% in August after a robust 0.6% increase in July.  If unchanged in September, these orders would be up at a 3.1% annualized rate in Q3 versus the Q2 average.  While employment and inflation remain under the spotlight as the Federal Reserve looks very likely to continue the rate cut process at the next meeting in October, we will also be paying close attention to how businesses – and consumers – are responding to the certainty now in place from the passage of the tax bill, which should enhance the competitiveness of US companies.  In other news this morning, initial jobless claims fell 14,000 to 218,000 while continuing claims slipped 2,000 to 1.926 million. Pairing these figures with other recent data on employment suggests modest continued job growth in September.

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Implications:  New home sales wrapped up the summer buying season with an unexpected bang, posting the largest monthly gain since 2022, and coming in higher than any economics group surveyed by Bloomberg expected. Looking at the big picture, buyers purchased 800,000 homes at an annual rate, and sales are up 15.4% in the past year. While the August pace remains below the highs of the pandemic, sales today broke above pre-pandemic levels which had been a ceiling of sorts for activity the past couple of years.  Although the housing market continues to face challenges (and one month of data doesn’t make a trend), there has been progress recently. First, financing costs have been trending lower, with the average 30-yr fixed mortgage rate now around 6.3%. Notably, that is the lowest since 2023, and with the Federal Reserve restarting rate cuts last week, buyers have reasons for further optimism. Meanwhile, prices have been trending lower for new builds the past several years. Median sales prices are down 10.2% from the peak in October 2022.  The Census Bureau reports that from Q3 2022 to Q2 2025 (the most recent data available) the median square footage for new single-family homes built fell 6.8%. 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 is partially 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 300% versus the bottom in 2022 and is currently at the highest level since 2009. This contrasts with the market for existing homes which continues to struggle with convincing current homeowners to give up the low fixed-rate mortgages they locked-in during the pandemic to list their homes. It looks like a combination of lower mortgage rates, less expensive options, and an abundance of inventories may finally be giving home sales a boost. In other recent news, the M2 measure of the money supply rose 0.4% in August and is up 4.8% from a year ago.  This remains below the 6% growth that has been normal over the past few decades, and as we argued in this week's MMO, we believe recent data supports modest rate cuts from the Federal Reserve. On the manufacturing front, the Philadelphia Fed Manufacturing Index, a measure of factory sentiment in that region, rebounded to a still weak reading of -12.3 in September from -17.5 in August. Finally, its counterpart the Richmond Fed Index fell to -17.0 in September from -7.0 in August.

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The stock market surged to new highs after the Federal Reserve cut the federal funds rate last week and the futures market has priced in more cuts to come.  However, these cuts have not helped reduce long-term interest rates and the price of gold has surged to over $3,700 an ounce.

Clearly, many investors are concerned rate cuts are unwarranted.  After all, the Consumer Price Index is up 2.9% in the past twelve months, which is higher than it was a year ago.  We won’t get August PCE inflation – the Fed’s preferred measure – until Friday, but it looks like these prices are up 2.8% versus a year ago compared to 2.3% in the year ending in August 2024.

Either way, it looks like we are further from the Fed’s 2.0% target for inflation than we were a year ago, so isn’t cutting rates playing with the inflation fire?

We think inflation is always and everywhere a monetary phenomenon, just like Milton Friedman explained many decades ago.  Some economists, including those at the Fed, think the money supply is no longer useful.  But, without the money supply, they still don’t have a good explanation for why inflation surged to 9.1% by 2022, the highest since the early 1980s.

After all, the Fed held short-term interest rates near zero for seven years (2008 – 2015) in the aftermath of the Great Recession and inflation remained under control.  During COVID, it only held rates at zero for two years.  If seven years of zero didn’t cause inflation, how did two?  The only solid explanation is the money supply, which remained contained after 2008 because of more stringent capital and liquidity rules on banks.  During COVID the Fed loosened those rules, facilitating an unprecedented 40% surge in the M2 measure of money over a two-year period.  That’s why we had an inflation surge.

Yes, we understand COVID lockdowns and deficit spending were highly unusual.  We also understand that the lags between shifts in the money supply and subsequent inflation can be long and variable.  But it’s hard to see how the M2 surge from 2020-22 would still be having a major effect today.

Inflation is much lower than its peak and that aligns with much slower money growth in recent years.  M2 contracted (which is highly unusual) in 2022-23 and since then is up at an average annualized rate of only 3.9% and up only 1.7% versus the 2023 peak.  For comparison, M2 grew about 6% per year in the decade prior to COVID with much lower inflation.

Yes, tariffs raise the prices of some items, but if the money supply doesn’t change, prices for other things must fall.  For example, home prices have flattened in recent months and rents for new tenants declined 8.4% in the second quarter this year, the steepest drop on record for any quarter going back to 2005.  In time, this will have an impact on the government’s measure of rent, which will help put downward pressure on inflation measures, as well.  In other words, the Fed may be cutting rates, but it’s the money supply that matters.

More importantly, after years of holding rates below inflation, interest rates are now above inflation.  In other words, the Fed is not unwarranted in cutting rates.  The rate cuts priced into the market still leave the “real” federal funds rate in positive territory.  They are not just because of political pressure.

Are we concerned about Fed independence?  Yes, monetary policy should not be controlled by politicians.  But the Fed has only itself to blame.  It did not act independently during 2008 or COVID when quantitative easing and zero percent rates provided the fuel for an unprecedented surge in government deficit spending.  The inflation that followed (what we call political kryptonite) forced the Fed and politicians to accept higher interest rates and quantitative tightening.  Politicians and the Fed may want to keep money easy, but markets have the final say.

To summarize, don’t just watch interest rates.  Watch the money supply too.  For now, we think some modest cuts in short-term rates are warranted.  But a surge in the M2 measure of money, if it happens, would change our minds.  The Fed often claims to be “data dependent.”  In a better world, the money supply would be a major part of the data they are dependent on.

Brian S. Wesbury – Chief Economist

Robert Stein, CFA – Deputy Chief Economist

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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.

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