Implications:  The job market was hot in October, with plenty of good news to go around.  Nonfarm payrolls rose 165,000, beating the forecast from every Economics Group on Bloomberg.  In addition, payrolls were revised up by 84,000 for prior months, bringing the net gain to 249,000.  Civilian employment, an alternative measure of jobs that includes small-business start-ups, rose 463,000 in October, while the labor force (people who are working or looking for work) gained 421,000.  This helped push the headline unemployment rate down a tick to 4.1% from 4.2%, but it was really a rounding issue, with the precise rate barely budging to 4.141% from a prior 4.175%. More good news: average hourly earnings increased 0.4% in October, which outpaced consensus expectations for inflation for the month.  Meanwhile, wages are up 3.1% from a year ago, which is lagging consumer price inflation but could help the Federal Reserve justify not raising short-term interest rates as much as the market now expects.  In the past year, private payrolls are up 79,000 per month, defying fears of an AI-related job apocalypse, with manufacturing and construction combined up 16,000 in October and up 196,000 so far this year.  By contrast, government jobs are down 58,000 in the past year and -225,000 since January 2025.  In other recent news, new claims for jobless benefits declined 6,000 last week to 189,000.  The four-week moving average is now 189,000, the lowest since 1969.  Continuing claims rose 23,000 but remain low at 1.718 million.  Also, productivity (output per hour worked) in the nonfarm business sector increased at a 3.6% annual rate in Q3 and is up 2.1% from a year ago.  Unit labor costs (how much workers are paid per unit of output) declined at a 0.7% rate in Q3 while still up 2.4% from a year ago.  The drop in Q3 doesn’t mean workers’ earnings are outright falling; they just didn’t rise in Q3 as fast as production.

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Last week, the Federal Open Market Committee (FOMC) held short-term interest rates steady but left the door open for another hike before year-end, as concerns over resurgent inflation continue to mount. But will higher interest rates really solve the problem? In today’s “Three on Thursday,” we examine what’s driving inflation and how those pressures are evolving. To find out more, click the link below.

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Implications: The pace of growth in the service sector took another small step back in October, with the ISM Services index falling to 54.5, the second consecutive monthly decline. That said, service activity has shown resilience in the face of multiple headwinds this year.  Despite the prices index hovering close to its four-year high, the overall services index has registered above 53.0 for the past eleven months, the longest streak since 2022.  Looking at the details, overall growth was broad in October with fifteen of the major service industries reporting expansion, while two reported contraction and one reported no change.  The major measures of activity were mixed in October. The business activity index fell once again to 53.8, a steep fall from the three-year high of 61.7 reached in August, although it has signaled expansion for twenty-eight consecutive months. The new orders index also declined to 55.9, but it is still elevated compared to a year ago, helping to push the backlog of orders index up to 58.0, its highest level since 2022. With orders piling up, firms have begun to pick up the pace of hiring, with the employment index rising to 51.4 from 50.1 in September.  While two months does not make a trend, it is a welcome sign for an industry that has struggled to consistently hire for the past three years. Survey comments reveal a cautiously optimistic outlook, with firms citing higher demand but continued pressure from elevated costs and higher interest rates. One comment from the Information industry states that “Fuel prices are impacting many of our consumables and delivered goods. This has reduced margins, as we have not passed the expense to our customers because we believe it will be a short-term condition.” Unfortunately, the highest reading of any index was once again the prices index, which fell slightly to 73.0 in October, now the seventh time this year the index has breached 70.0. Though the index remains elevated, it remains below the worst we saw during COVID when M2 surged by 42% and the prices paid index reached the low 80s. 

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Implications: The trade deficit narrowed slightly to $105.0 billion in September, taking a breather after steadily widening since the beginning of the summer. The deficit now hovers around the largest since early 2025, back when importers were front-running the Trump Administration’s “Liberation Day” tariffs promised for April 2025.  Looking at the details, the slight drop in the deficit was due to a $5.8 billion increase in exports more than offsetting a $5.2 billion increase in imports. The rise in exports was led by soybeans, computers, and crude oil. Total exports are up $241 billion year-to-date compared to the same time last year, driven in part by a price increase in petroleum-based exports, which have accounted for just over a third of that increase.  In fact, September marked the 55th consecutive month of America being a net exporter of petroleum products.  Keep in mind that while the U.S. exports petroleum products (gasoline, diesel, and propane) in large volumes, it remains a net importer of crude oil, largely due to domestic refining capabilities.  On the import side, computers, computer accessories, and pharmaceuticals led imports to the highest level on record in September. The surge in imports over the past year has been driven by the wave of massive capital spending on computer processing – imports of computers, computer accessories, semiconductors, and telecommunications equipment are up $332 billion year-to-date versus the same period last year, compared to just $180 billion in overall imports. Yes, that means the tech sector alone accounted for more than the entire increase in the trade deficit, likely due to the build-out of AI and data centers. In fact, computers and electronic products comprised 34.8% of all goods imports in September, the largest share of any product category on record going back to 1999. This dynamic has propelled Taiwan to become one of our closest trade partners, with imports from the country up 60.5% year-to-date versus the same time last year. On the other hand, the official figures show that China, once the dominant exporter to the U.S., has slipped to a fourth place behind Mexico, Canada, and Taiwan, with exports to the U.S. down 11.5% year to date compared to the same period last year.  We say “official figures” because it is also possible that China is now laundering some of their exports to the U.S. through other countries.  Meanwhile, the total volume of trade, exports plus imports, which shows the extent of business and consumer interaction across the border, increased $11.0 billion in September. This measure has risen 16.1% in the past year, with exports up 10.0% and imports up 21.3%.  In other news this morning, ADP's measure of private payrolls increased 86,000 in October versus a consensus expected 67,000. We're estimating Friday's official report will show a nonfarm payroll gain of 67,000 with the unemployment rate remaining steady at 4.2%.

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Implications: Activity in the manufacturing sector continued expanding in October, beating expectations and rising at the second fastest pace since 2022.  Activity has now expanded for ten consecutive months, an encouraging development for an industry that faced significant challenges from 2023-2025, and which now appears to be benefitting from AI-related capital investment, the reshoring of production, and increased defense procurement.  Looking at the details of the report, twelve out of the eighteen major manufacturing industries reported growth in October, with three industries reporting contraction, and three reporting no change. The major measures of activity moved mostly higher for the month, with all standing above 50, signaling growth. New orders hit a three-month high in October, matching the headline level of 55.5. Up until this year, new orders had been very weak going back to 2023, but explosive growth from the semiconductor and government/defense spaces (particularly in the machinery industry) have led to a strong rebound in 2026.  Along with this rise, order backlogs (which sat in contraction territory for more than three straight years before 2026) have grown each month this year and currently sit in solid expansion territory at 54.6.  The best news in the report is that the improvement in demand has finally convinced manufacturers to start adding workers, with hiring activity expanding for the fourth consecutive month after nearly three straight years of contraction.  Meanwhile, production has ramped up to the fastest pace since late 2021, with the index increasing to 59.0 in October. The worst news in the report is that inflation pressures remain a problem in the manufacturing sector, as the prices index declined to a still-elevated 75.2.  The report notes that the prices index has been driven by (1) increases in steel and aluminum prices that impact the entire value chain, (2) tariffs applied to imported goods, and (3) increases in petroleum-based products as a result of the Middle East conflict.  This further strengthens our expectation for the Federal Reserve to hike short term interest rates at the meeting in December, although the trend growth in the M2 money supply suggests broad inflation will come down faster than most investors expect in the year ahead.  In other news this morning, construction spending declined 1.9% in September, as a huge drop in home construction more than offset sizable increases for office and power projects.

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In spite of all the angst, the economy keeps growing, with real GDP growth clocking in at a 3.4% annual rate for the third quarter, led by strong consumption and business investment, with much of both powered by the expansion of AI and data centers.  In addition, it looks like the economic momentum will carry into the end of the year, with the Atlanta Fed’s GDP Now model starting off projecting Q4 growth at a 3.2% rate.

This growth helps explain why the job market continues to show resilience.  Initial claims for unemployment insurance have averaged 197,000 per week in the past four weeks, the lowest since October 1969, back when the total labor force (people who are either working or looking for work) was less than half what it is today, and so there were way fewer people available to be unemployed.

We estimate that nonfarm payrolls rose 67,000 in October, which is also about the average for the past six months.  Yes, there have been other periods when job growth has been stronger, but none when net immigration has been near zero or below while the native population has been aging.

The Federal Reserve also met last week and decided to leave short-term interest rates unchanged, postponing another quarter-point rate hike to December.  The futures market is pegging the odds of a rate hike at about 75%; we think the odds are higher.

The potentially more interesting news is that Chairman Warsh got the Fed to shrink the number of “live” policy meetings in 2027-28 when rate cuts or hikes will be actively discussed, instead leaving some meetings for general discussions about the direction of policy.  We like the effort to update the way the Fed operates, but relative to the broad array of major changes the Fed could be making, this seems a bit….wimpy.

Yes, we are aware Warsh has already set up working groups to consider major reforms.  But, in the meantime, does anyone seriously think that if important shifts in monetary policy are needed that the Fed will skip a meeting anyhow because it was pre-scheduled for general discussion rather than policy votes?

To be generous, maybe Warsh’s goal is to reduce the markets’ obsession with speculating on policy shifts.  But a better way might be to get out of the habit of “drip drip drip” policy shifts.  Back in September the Fed raised rates a quarter point and used the “dot plots” to signal another quarter point rate hike was likely by year end.  So why not just move by half a percentage point in September?  And why not get in the general habit of moving rates to where the Fed itself is evenly split about whether the next move is a rate hike or a rate cut?  

In the meantime, we believe the Fed should pay more attention to reducing the costs associated with the regional reserve banks, from banking supervision to economic research.

Ultimately, we suspect there are more changes in store for the Fed, but they will need to wait for former Chairman Powell to leave the Board, which would allow him to be replaced by someone more willing to reconsider the status quo.

Brian S. Wesbury – Chief Economist

Robert Stein, CFA – Deputy Chief Economist

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How many missiles does the U.S. really have, and are we running out? In this week’s “Three on Thursday,” we dive into the current U.S. missile inventory, how it has been impacted by the war in Iran, and what the military is doing in response.  To find out more, click the link below.

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Implications:  Consumers continue to spend at a healthy clip, but inflation ate into their purchasing power in September.  Starting with prices, which remain in the spotlight as the Fed set the table yesterday for a rate hike at the next meeting in December, PCE prices rose 0.5% in September and are up 3.6% in the past year. Gasoline and other energy goods prices rose 9.1% in September, leading the overall increase.  Meanwhile “core” prices – which strip out the volatile food and energy components, rose 0.3% in September and are up 3.1% from a year ago.  Inflation remains notably above the 2.0% target, and we aren’t arguing for the Fed to cut rates, but we believe the market is pricing in more hikes for 2027 than will come to pass.  The M2 measure of the money supply rose 0.5% in September and is up 5.7% in the past year, in line with the 6% average growth rate seen in the 2010s when inflation ran consistently below 2%, and we expect inflation will trend toward the Fed’s target in the year ahead even without further rate movement.  Moving on to personal income - which rose 0.2% in September – shows growth was led by private sector wages and salaries (up 0.2% in September and 4.6% in the past year) and government transfer payments, (+0.3% in September and +4.2% from a year ago).  While wage growth near 5.0% sounds strong, it’s important to remember that the ongoing above-trend inflation has taken a big bite out of consumers’ purchasing power.  Case in point, personal consumption rose a healthy 0.5% in September, led by spending on gasoline and other energy goods, transportation services, and housing, but with prices also up 0.5% it means the increase in spending didn’t buy more things, it simply kept pace with inflation. Spending has been running hot in 2026, with September marking the sixth time since the start of the year that consumption grew over 0.5% in a month.  That has helped to outpace inflation, but it is also outpacing income.  The personal saving rate — which tracks how much after-tax income is not consumed — declined to 3.8% in September and remains near the lowest readings since the COVID-era in 2022 (and before that during the Great Financial Crisis in 2008!).  This low level of saving allows for more spending today but isn’t sustainable long-term.

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Implications:  Real GDP grew at a solid 3.4% annual rate in Q3, close to the consensus expected 3.2%, with details that were even stronger than the headline. Personal spending was the key driver for economic growth in the third quarter, growing at a 3.8% rate, well above its 2.5% increase in the past year.  However, the AI/data center build-out also remains a very important factor.  Data center construction grew at a 127% rate, business investment in information processing equipment grew at a 37.3% pace, investment in software grew at a 9.6% rate, and R&D was up at a 7.6% pace. This surge in investment has also led to a significant increase in imports of technology-related equipment. As a result, net exports were a significant drag on growth in Q3, subtracting 3.3 percentage points from real GDP, the largest drag from this category since 1947, other than the tariff front-running of Q1 2025.  Meanwhile,  growth from inventories and government purchases added an unusually large 2.5 percentage points to growth, providing a temporary boost that is unlikely to continue over the next year. The best news in today’s report was that Core Real GDP – which includes consumer spending, business fixed investment, and home building, and excludes more volatile categories like government purchases, inventories, and international trade – grew at a 4.9% rate in the third quarter, the fastest pace in more than five years, and is now up 3.3% from a year ago.  There is reason to believe Core GDP will remain elevated given that the AI investment boom has shown no signs of slowing, but the above-trend growth in consumption suggests the Q3 increase in Real GDP may not signal a new trend to higher growth. The jury is still out. And with the AI investment boom showing no signs of slowing down, there is reason to believe Core GDP will remain strong in the quarters ahead. In the meantime, inflation trended lower in the third quarter, with GDP prices up at a 2.3% rate in Q3, down from a 6.1% rate in Q2, but still up 3.7% from a year ago.  As a result, nominal GDP rose at a 5.6% pace in Q3 and is up 5.7% annualized in the past two years, which suggests the Federal Reserve has room to raise its federal funds target rate from the current level of 3.875%.  In other news this morning, new claims for unemployment insurance declined 1,000 last week to a very low 194,000.  Continuing claims declined 21,000 to 1.701 million.  These figures suggest moderate payroll growth in October.

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The Federal Reserve held rates steady at the last meeting before the mid-term elections, while setting the table for a likely rate move in December.

Before we dive into the details, Chairman Warsh announced a new protocol for Fed meetings starting in 2027.  Next year the Fed will continue to hold eight FOMC meetings, but one of those meetings will focus specifically on monetary policy strategy and will not include a vote on rates.  In 2028, there will again be eight meetings but two of those meetings will focus on strategy and not on rates.  In other words, there will be fewer meetings spent setting interest rates, and more time committed to ensuring the FOMC has clear goals and strategies to operate under moving forward.

Within the Fed statement, there were minimal changes to language.  The economy is seen as expanding at a “strong” pace, spending is “resilient”, and capital investment is “robust”.  But uncertainty also remains elevated in part due to geopolitical events, and inflation is still above target.  This is very much the same story that the Fed noted back in September. The only substantive change came in new “hold” language stating that “The accumulation of more information will help the Committee determine the policy stance appropriate to ensure a timely return of inflation to the Committee’s 2 percent goal.”   

In the press conference, Warsh faced multiple questions asking why the Fed paused further rate hikes today when inflation remains above the 2% target. In short, Warsh noted that the rate hike made six weeks ago has had the generally expected impact – though it’s still early – and hikes come with other potentially negative impacts on areas like employment that need to be considered.  The Fed does not view the current rate environment as “tight,” but some recent tightening in financial and credit conditions suggest a movement in the right direction.  Over the next six weeks, the Fed will watch to see if the data confirm ongoing improvements, or if additional rate hikes are warranted.

The most notable statement from Warsh came in response to questions related to how the AI boom is impacting demand, and in turn, inflation.  The general feeling amongst the FOMC is that the economy is not running too hot or too strong in today’s intensive AI-investment environment that is seeing historic levels of capex spending.  In their view, economic and productivity growth in the economy remains strong and is broadening.  So for now, the Fed does not want to “throw sand in the gears” of the economy by raising rates to slow demand.

We would argue that without data center spending the economy would be weaker.  Housing and auto sales remain subdued. So, holding rates steady is not indefensible.    

We do expect, however, the FOMC will raise rates once again in December, but believe further hikes after that will be fewer than the markets are currently pricing in.  Unless oil prices once again rise substantially, the impact on year-ago inflation readings will moderate in the spring, while any resolution to the conflict in the Middle East is likely to bring easing to inflation concerns and put the Fed on a prolonged pause.    

Brian S. Wesbury, Chief Economist

Robert Stein, Deputy Chief Economist

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