Implications: Industrial production slowed from its rapid pace in April, posting a modest 0.1% gain in May.  The largest positive contribution came from a 1.3% jump in the mining sector, where gains were broad-based across oil and gas extraction, drilling activity, and other mineral extraction. One month does not make a trend, but the increase is an encouraging sign that US energy companies may finally be ramping up output as supply disruptions continued in the Middle East.  Meanwhile, the manufacturing sector stalled for the first time this year despite a 1.2% increase in the volatile auto sector.  Manufacturing excluding autos (which we think of as a “core” version of industrial production) was unchanged in May, even though the typical bright spots in the “core” measure were present.  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, increased 1.8% in May with previous months’ activity revised higher.  High-tech manufacturing is up 12.6% in the past year and up at an even faster 19.8% annualized rate in the past six months, the fastest growth rates for any major category. Meanwhile, manufacturing of business equipment rose 0.6% in May and is up 5.7% in the past year, signaling a broader reindustrialization. Weakness in core production was concentrated in nondurable manufacturing, with output declining in chemicals, petroleum and coal products, plastics and rubber products, and textiles, suggesting that higher energy costs (which are key inputs for these industries) may be weighing on production.  Given the recent agreement with Iran and drop in oil prices, production in these industries should rebound in the months ahead.  Finally, utilities output (which is volatile and largely dependent on weather from month to month) retreated 0.4% in May.  However, if we look at the broader picture this series has been on an upward trend since 2023, following nearly twenty years of stagnation, as power hungry data centers have boosted demand for US power generation. In other news this morning, the Empire State Index – a measure of factory sentiment in the New York region – declined to +5.7 in June from +19.6 in May.

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This week the Fed has its first meeting under new Chair Kevin Warsh.  For only the third time in US history, the former Chair, Jerome Powell, will still participate as a regular member of the Board of Governors.

While many will frame this meeting as a battle between two people, the data are not clear enough to argue for either a rate hike or a rate cut, no matter who is in charge.  The economy and jobs continue to grow, and while many think they see evidence of rising productivity, inflation has been higher than expected.  We think this is because of the Iran conflict, but only time will tell.  And with a peace agreement in place, we will find out soon.

One change that Warsh is likely to push for is an end to “forward guidance.”  He has spoken out against this practice, where the Fed tries to guide markets about the future path of short-term rates.  Most members would not find this particularly controversial and would likely support it.

Other possible changes could be to the “dot plots” and economic forecasts – updated versions of which the Fed is supposed to deliver on Wednesday – or the schedule of how frequently the Fed holds post-meeting press conferences.  Changes to the regional bank structure and a move to reduce abundant reserves will take much more time.

But, lurking in the background of all this – and what could determine the eventual path of monetary policy – is a debate about productivity.  Warsh has said we could be on the verge of an AI-led acceleration in productivity growth.  If so, inflation might be tamed more easily than expected in the next couple of years.

Typically, the Fed would view faster “real” (inflation-adjusted) economic growth as a signal that monetary policy is easy and rate hikes might be warranted.  But if the economy is being lifted by faster productivity growth, then the Fed can let the economy run, and may even want to cut rates because productivity would hold inflation down.

We present data here with the full understanding that productivity (output per hours worked) is very hard to measure.  This is especially true when net immigration has come to a virtual standstill and government employment has fallen at historically fast rates.  In other words, the economy has continued to grow while the labor force and employment have slowed.

The result is a rise in measured productivity growth.  In the past three years, official productivity has climbed at a 2.7% annual rate in the nonfarm business sector, compared to an average of 1.8% since the mid-1970s.

Three years is not a very long period of time, but since the pre-COVID peak in the business cycle in 2019, productivity is up at a 2.1% annual rate versus a slower 1.5% pace in the twelve-year business cycle that ended right before COVID (from the last quarter of 2007 through the last quarter of 2019).

Overall real GDP is up 2.6% in the past year.  And this happened with an increase in the unemployment rate.  The way the Fed looks at the economy, “potential” growth is the rate at which the economy can expand without causing it to overheat.  So, if the unemployment rate is rising, it signals that monetary policy might be too tight.  In other words, using typical Fed models, it would have taken an even faster economic growth rate to keep the unemployment rate stable.  In turn, this suggests the “growth potential” of the economy has improved.

However, there are also reasons to be skeptical about the theory that productivity growth has accelerated.  For one thing, the size of the federal government relative to GDP has grown substantially since 2008.

Another is that while AI has been incorporated in various technologies for years its wide use is relatively new.  Most importantly, excluding the massive investment in data centers, GDP growth has been very slow.  This is reminiscent of the late 1990s boom in dot.com technology.

In other words, there is some evidence of higher productivity, but it is way too early to declare this a real fact.  For now, the Fed is on hold, new Chairman or not.  

Brian S. Wesbury – Chief Economist
Robert Stein, CFA – Deputy Chief Economist

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Since 2008, the Federal Reserve (the “Fed”) has operated under an “abundant reserves” framework, a significant departure from its prior monetary policy approach. While the Fed believes this system helped support financial markets and economic activity, it has also produced some notable side effects. Last month the Fed released its latest quarterly financial report for Q1 detailing the combined financial position of the 12 Federal Reserve Banks. Click the link below to find out more.

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Implications: The ongoing conflict in the Middle East continues to fuel inflation, as producer prices rose 1.1% in May, matching the increase from last month for the fastest pace in four years.  Unlike in April where we saw a broad increase across categories, the surge in May was mostly limited to energy, which jumped 10.7%, driven by a 23.4% surge in gasoline prices.  The 2.8% rise in goods prices marked the largest on record since the series began in December 2009. In turn, goods were responsible for nearly eighty percent of the headline increase.  Looking at the services side of the index tells a different story, with prices rising a more modest 0.3%, where close to half of the advance was concentrated in portfolio management fees, which rebounded 4.8% after falling 2.3% in April.  Meanwhile, final demand trade services (which measures the margins received by wholesalers and retailers) declined 1.1% in May.  Further back in the supply chain, prices for unprocessed and processed intermediate goods rose 4.9% and 3.5% respectively.  Here price pressures were overwhelmingly led by energy processing, underscoring the spillover effects that higher energy costs have on the economy. We expect volatility and uncertainty to continue in the months ahead as the ongoing conflict in Iran puts further pressure on oil prices and global supply chains. However, sustained movements in overall inflation are led by the money supply, which is up 4.7% in the past year versus the 6% trend prior to COVID when inflation remained low. We expect this monetary tightness will eventually bring inflation down once the conflict in the Middle East ends. Until then, incoming Fed Chair Kevin Warsh and the FOMC are unlikely to do anything with rates.  In employment news this morning, initial jobless claims rose 4,000 last week to 229,000, while continuing claims increased 24,000 to 1.795 million.

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Implications:  The ongoing conflict in the Middle East continues to dominate the inflation data, as consumer prices rose 0.5% in May after outsized increases in March and April.  More than half of the May increase came from energy, where gasoline jumped 7.0%.  The “core” CPI, which excludes food and energy, rose a more modest 0.2% in May, below the consensus expected +0.3%.  Consumer prices are up 4.2% in the past year, the largest twelve-month increase since early 2023, while “core” prices have increased 2.9% in the past year, nearly identical to the 2.8% pace for the twelve months ending May 2025. While we expect the effects of higher energy costs to largely reverse once the conflict ultimately winds down, the timing remains uncertain, leaving the Federal Reserve with little conviction as the FOMC meets next week for the first time under new Chair Kevin Warsh.  In addition to our first look at a Chair Warsh press conference, next week’s meeting will also include economic forecasts (the dot plots) from FOMC members, so we will get a chance to see how long the Fed expects inflation to stick around.  While we may disagree on how long price pressures are likely to continue, what is clear is that inflation remains well above the Fed’s 2.0% target no matter how you cut it.  Beyond food and energy, the May increase was once again led by housing rents (those for actual tenants as well as the imputed rental value of owner-occupied homes), which are the largest components in the index.   Recent data on both home prices and rents suggest that housing inflation should moderate in the months ahead following the April surge which was a statistical quirk related to a lack of comparison data due to last year’s government shutdown.  Other notable movers in the core group include airline fares (+2.7%), communication (+1.3%), and hospital services (+0.7%), which were partially offset by falling prices for auto insurance (-1.7%) and prescription drugs (-0.9%).  The worst news in today’s report was that wages continue to lose ground to inflation, as “real” inflation-adjusted hourly earnings declined 0.1% and are now down 0.7% in the past year.  Between large tax returns and a decline in the saving rate, consumers haven’t yet pulled back on spending in other categories to offset higher energy costs, but that can’t last.  We will continue to focus on developments in the M2 money supply, which we believe is the most reliable tool for forecasting sustained inflation and which suggest that once the Iran War is resolved, inflation is likely to drop faster than most investors expect.

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Implications: Existing home sales beat expectations in May, rising 3.2% to the fastest pace of sales this year.  Despite topping every forecast submitted to Bloomberg, activity remains disappointingly low.  Looking at the big picture, sales have been stuck around a 4.000 million pace for three years now, about the same pace as in the aftermath of the Great Financial Crisis, and well below the roughly 5.250 million annual pace pre-COVID (let alone the 6.500 million pace during COVID).  The main issue remains affordability which has taken a turn for the worse recently due to the Iran War raising energy costs and having an upward impact on short-term inflation.  The result has been a rapid increase in 30-year mortgage rates, which have moved 50 basis points higher since February and now sit around 6.6%.  Higher inflation also takes further easing from the Federal Reserve off the table, with the futures market now pricing in a quarter-point rate hike later this year. But as we wrote yesterday, we believe the inflationary impact of the Iran war is temporary given the tight monetary conditions that preceded it, and expect both inflation and interest rates to move lower after the conflict subsides.  Buyers also face an ongoing headwind from tight inventories.  The good news is that existing-home inventory is tied for the highest level since the pandemic.  That said, the months’ supply of homes (how long it would take to sell existing inventory at the current very slow sales pace) was 4.5 in May, below the benchmark of 5.0 that the National Association of Realtors uses to denote a normal market.  Many existing homeowners also remain reluctant to sell due to a “mortgage lock-in” phenomenon, after buying or refinancing at much lower rates before 2022.  This means potential buyers will have to continue to deal with limited options.  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. The good news for buyers is that the median price of an existing home is up only 1.3% versus a year ago. Aggregate wage growth (hourly earnings plus hours worked) has been consistently outpacing median home price gains over the past year for the first time since 2023, which improves affordability. While May's report was a welcome sign, we expect these cross currents to keep activity constrained for the near term.

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Implications: The trade deficit shrunk slightly to $55.9 billion in April, continuing its break from the volatility that dominated trade reports for much of last year.  Despite the small movement in the deficit, there was plenty of activity behind the scenes: exports rose by $8.3 billion, led by crude oil, as domestic producers moved to fill the void left by the war-driven closure of oil flows through the Strait of Hormuz.  The increase in exports was larger than the $7.6 billion increase in imports, led by led by computers and semiconductors. We like to focus on total volume of trade, exports plus imports, as it shows the extent of business and consumer interaction across the border. That measure increased by $15.9 billion in April and is up 10.7% from a year ago.  In the past year exports are up 12.6% while imports are up 9.1%.  Meanwhile, the landscape of global trade continues to evolve. China, once the dominant exporter to the U.S., has slipped to a fourth place behind Mexico, Canada, and now Taiwan, with exports to the U.S. down 37.1% in the first four months of 2026 compared to the same period last year.  Accelerated demand for high tech equipment to fuel the massive AI investment stands out in the data with imports from Taiwan up 88.1% over the same period moving them a full 6 places higher from 9th to 3rd.  Also in today’s report, the dollar value of U.S. petroleum exports once again exceeded imports, with the U.S. posting its largest petroleum surplus on record going back 30 years in April, marking the 50th consecutive month of America being a net exporter of petroleum products.  Keep in mind petroleum products include refined products like gasoline, diesel, and propane – all of which the U.S. exports in large volumes. When looking at crude oil alone however, the U.S. remains a net importer (although not as much as in prior decades), largely due to domestic refinement capabilities.

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The job market was surprisingly strong in May with non-farm payrolls growing 172,000, beating even the strongest forecasts for the month.  As a result, the futures market is now pricing in a quarter-point rate hike later this year and more likely than not another quarter point rate hike sometime in 2027.

But we think rate hike would be ill-advised and unlikely.  First, this is a good employment report, but not a “barnburner.”  Barnburner job growth is 300,000 to 400,000 per month.  Even Keynesians who think strong job growth causes inflation, are over-reacting.

Second, yes, the CPI is up 3.8% versus a year ago and the Fed’s preferred inflation measure, the PCE Deflator hasn’t been at or below 2.0% for more than five years.  But we think without the Iran War temporarily boosting prices, the Fed had already set the stage for a return to 2.0% inflation.  The M2 measure of the money supply is up 4.7% from a year ago and has been up at a 3.2% annual rate in the past three years.  By contrast, in the ten years prior to COVID, when inflation was consistently below the Fed’s 2.0% target, the money supply was up at a 6.2% rate.  

In other words, the money supply has been growing slowly enough for inflation to be brought under control.  However, the war has caused oil prices to soar, lifting official measures of inflation.  Over time, higher oil prices will mean less money for consumers to spend on other products, which will push other prices down.  

But in the short run, consumers have reacted to higher oil prices by running down their saving rate.  In January consumers saved 4.3% of their income.  Yes, that’s low historically, but nothing compared to the 2.6% saving rate in April.  That may not seem like much, but if the new lower saving rate keeps up for a year, consumer saving would be down by $400 billion versus where it was in January.  That reduction in the saving rate temporarily gives ample room to pay for higher oil prices without putting downward pressure on the prices of other goods and services.

Don’t mistake this argument for the one used several years ago when former Fed Chairman said the increase in inflation was “transitory.”  Back then inflation measured by the PCE Deflator peaked at more than 7.0% – the highest in forty years – and the M2 measure of the money supply had skyrocketed about 40%.

On the other side of the conflict with Iran (whenever that is) are lower prices for energy, consistent with modest growth in the money supply and a re-assertion by consumers of a higher pace of saving.  It is possible that this conflict drags on.  Iran is not negotiating in good faith and flew missiles into Israel last night.  But even if this war continues, and inflation stays elevated, it would be wrong to raise rates.  Why hit consumers, whose spending is already growing faster than their incomes, with a rate hike on top of everything else?  Higher oil prices are a drag on growth…why compound it?

Other indicators are consistent with lower inflation.  For example, in spite of robust job growth, average hourly earnings are up only 3.4% from a year ago, matching the slowest pace in five years.  This is consistent with 2.0% inflation plus the long-term trend of 1.5% productivity growth.  If productivity growth is faster than that right now – and we will be writing about this issue in the weeks ahead – then 3.4% wage growth is an even better signal that monetary policy is already tight enough to bring inflation back down to 2.0% (after the Iran War).

As we said earlier, job growth doesn’t cause inflation, but neither do rising wages.  The Fed operates on a Keynesian model that thinks strong growth causes inflation.  It’s wrong, but still does it.  So, what will it focus on temporarily higher inflation, or moderate wage growth?  Raising rates is a mistake.

Other measures of inflation have been lower.  For example, the Dallas Fed’s measure of “trimmed mean” inflation, which ignores the most volatile categories of prices, is up only 2.4% from a year ago, down from 2.6% in April 2025.

At present, we don’t think newly-minted Chairman Kevin Warsh has the votes to cut short-term interest rates, even if he wanted to.  But given modest wage growth and moderate trimmed-mean inflation, we think Warsh does have a political clout at the Fed to keep rate hikes at bay.  

The market sell-off on Friday was more than about a better-than-expected jobs number.  The market is overvalued.  We don’t expect a crash, but the idea that the market will only move one way (higher) has always been wrong.

Brian S. Wesbury – Chief Economist
Robert Stein, CFA – Deputy Chief Economist

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Implications: Whatever happened to the AI jobs apocalypse?  While AI investments dominate headlines and markets prepare for a string of historic tech IPOs, the jobs market is showing signs of strength.  Nonfarm payrolls rose 172,000 in May and 265,000 including upward revisions for prior months – easily beating the consensus expected 88,000.  Meanwhile, the unemployment rate remained at a relatively low 4.3%.  The job gains in May itself were led by leisure & hospitality, health care & social assistance, construction, and government.  Total hours worked in the private sector rose 0.1%.  We like to follow payrolls excluding government and health care & education (which are often driven by government policies), which rose 80,000 in May.  The May rise in government payrolls of 52,000 is the largest monthly increase in nearly two years, but comes following a string of declines that closed out 2025 and kicked off 2026.  Even with the May jump, federal payrolls excluding the Post Office and Census are down 330,000 from where they started last year.  Leaving out the end of the Census every decade, the decline in federal payrolls in the past sixteen months has been the steepest since the wind-down from World War II. Over time, we think a smaller federal government will help boost growth in the private sector.   Civilian employment, an alternative measure of jobs that includes small-business start-ups, rose 149,000 in May.  That series can be volatile month-to-month but is worth watching.  The unemployment rate remained steady at 4.3%, as the employment gains were accompanied by an increase of 83,000 in the labor force (people working or looking for work).  Average hourly earnings rose 0.3% in May, which given the recent (though we believe temporary) increase in inflation likely struggled to keep pace with higher prices for the month.  Put it all together and we expect continued jobs gains in the months ahead, though likely slower than in May.  In other recent news, initial jobless claims rose 13,000 last week to a still-low 225,000; continuing claims declined 8,000 to 1.777 million.  

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While the FOMC has kept rates steady throughout 2026, there is far from a consensus among the group. In this week’s “Three on Thursday,” we take a look at market rate expectations, inflation and money supply. To learn more, click the link below.

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