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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Implications: New home sales remained in low gear in September, as affordability continued to keep potential buyers on the sidelines. Sales are now at an annual pace of 676,000, right around pre-pandemic levels, which has been a ceiling of sorts for activity the past couple of years.  Unfortunately, ongoing conflicts in the Middle East and between Russia and Ukraine are having upward impacts on energy prices and inflation which have introduced new challenges. First, financing costs have risen, with the average 30-yr fixed mortgage rate up roughly 130 basis points since early this year.  Second, the Federal Reserve has begun hiking interest rates again, which will disproportionately impact the already weak housing sector. But while buyers are unlikely to get much help from interest rates, the good news is that prices have been trending lower for new builds in the past several years. Median sales prices are down 13% from the peak in October 2022.  Meanwhile, the Census Bureau reports that from Q3 2022 to Q2 2026 (the most recent data available) the median square footage for new single-family homes built rose 2.5%. So, buyers are seeing a drop in the price per square foot, not just smaller/lower cost options.  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 has been trending down recently but is still up 260% versus the bottom in 2022. This contrasts with the market for existing homes, which continues to struggle to convince current homeowners to give up the low fixed-rate mortgages they locked-in during the pandemic. While financing costs continue to add uncertainty and keep buyers on the sidelines, less expensive options and an abundance of inventories may give home sales a modest boost through the end of 2026. In other housing news this morning, the FHFA index increased 0.3% in August and is up 2.5% in the past year, while the national Case-Shiller index increased 0.3% in August and is up 2.1% in the past year.

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Implications:  New orders for durable goods surged in September, rising 1.8%, the second fastest monthly gain this year.  While the headline was boosted by a large increase in commercial aircraft orders, underlying activity remains robust due to a resurgence in capital investment.  Aircraft are often ordered in bulk, which is why orders excluding transportation provide a much better check on the broader economy. These orders continue to rise, up 0.5% in September, though growth has slowed slightly from earlier this year when monthly gains were consistently above 1.0%. That said, these orders are still up 11.1% in the past year.  The increase in September was led by industrial machinery (+1.2%), computers & electronic products (+0.8%), and primary metals (+0.5%).  Electrical equipment was the only major category to decline in September but is still up 4.8% in the past year.  All other categories have experienced a surge in growth in the past year – primary metals, industrial machinery, and computers & electronic products have each experienced double-digit growth in the last twelve months. The most important number in today’s release is core shipments – a key input for business investment in the calculation of GDP – which surged 1.2% in September, marking the eighth consecutive month of growth.  Core shipments were up at a 16.5% annualized rate in Q3 versus the Q2 average, an acceleration from the 11.6% pace in Q2.  These shipments are up 11.5% over the past year, the largest annual gain outside the COVID years since 2012, as capital spending from the hyperscalers, the reshoring of production, and a more favorable tax environment for investment have helped drive a strong increase.  In other manufacturing news, the Kansas City Fed Manufacturing Index, a measure of factory sentiment in that region, declined to +11 in October from +14 in September.  The Richmond Fed index, a measure of mid-Atlantic factory activity, remained at -2 in October.  On the employment front, initial claims fell 6,000 two weeks ago to 194,000 while continuing claims rose 25,000 to 1.728 million. These figures suggest continued job growth in October.

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We estimate the US economy grew at a 3.3% annual rate in the third quarter.  Solid.  Robust even, considering that net immigration is near zero and possibly negative, while Baby Boomers continue to gradually drift into retirement.

However, don’t get too excited.  Even if we get 3.3% for Q3, Real GDP will be up a modest 2.0% from a year ago.  And there are still signs that much of the growth is concentrated in AI and data centers.  Excluding that, the economy is tepid and could possibly get weaker if the Federal Reserve keeps raising short-term interest rates.

How strong is the tech sector?  Even if data center construction is (oddly) unchanged in September, staying at the August level, nominal spending on data centers will be up at an annual rate of 139% in the third quarter.  That is NOT a typo.  Meanwhile, the US production of semiconductors and related electronic components rose at a 47% rate in Q3, the fastest pace on record for any quarter going back to at least the early 1970s.

The bottom-line is that AI and data centers are booming, the rest of the economy is not.

Consumption: Auto sales declined at a 5.2% annual rate in Q3.  However, “real” (inflation-adjusted) retail sales excluding autos rose at a 3.5% rate and real service spending – which makes up the lion’s share of consumer spending – appears up at close to a 4.0% pace.  Combined, this brings our estimate of real consumer spending to a 3.7% rate, adding 2.5 points to the real GDP growth rate (3.7 times the consumption share of GDP, which is 68%, equals 2.5).

Business Investment: We estimate a 12.3% growth rate for business fixed investment with widespread gains in equipment, commercial construction, and intellectual property.  If we are right, with the exception of the immediate bounce back in 2020 after the COVID shutdown-induced collapse in the first half of that year, that would be the fastest growth for business fixed investment for any quarter since 2011.  A 12.3% growth rate would add 1.8 points to real GDP growth.  (12.3 times the 15% business investment share of GDP equals 1.8).

Home Building: Residential construction looks to have grown at a respectable 5.5% annual rate in the third quarter, but don’t get optimistic, yet.  Housing still faces headwinds in the form of local regulations, a lack of workers, higher mortgage rates, and a strict immigration policy that makes more units available for rent.  In the meantime, look for a 0.2 point add for Q3.  (5.5 times the 4% residential construction share of GDP equals 0.2).

Government: We estimate that government purchases rose at a 1.7% annual rate in Q3 after being roughly unchanged in Q2, which should add 0.3 points to the GDP growth rate (1.7 times the 17% government purchase share of GDP equals 0.3).

Trade: The trade deficit soared in the third quarter due to a surge in goods imports and a modest decline in goods exports, although this forecast may change when a preliminary trade report is released Wednesday morning.  For now, we’re projecting net exports will reduce the Q3 real GDP growth rate by 3.2 percentage points.  That’s huge and is partially due to the AI/data center buildout, which is driving a surge in imports of tech equipment, including semiconductors from Taiwan. 

Inventories: We estimate that businesses added to inventories in the third quarter after drawdowns in each of the previous five quarters. Going back to at least the late 1940s we have never experienced such a long drawdown in inventories without a recession.   However, some of it is due to the unusual nature of the Trump tariffs, which allowed for an inventory surge in early 2025 to front-run those tariffs.  The growth in inventories in Q3 should add 1.7 points to real GDP growth.

Add it all up, and we get a 3.3% annual real GDP growth rate for the third quarter, which masks extremely rapid growth in AI/data centers and slow growth elsewhere.

Brian S. Wesbury – Chief Economist

Robert Stein, CFA – Deputy Chief Economist

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This week’s edition of “Three on Thursday” focuses on the S&P 500 Index’s (the “Index”) performance over the first three quarters of 2026. So far this year through Q3, the Index has hit all-time highs 27 times, with a maximum drawdown (peak to trough) of 9.1%.  For a deeper insight into what has shaped the market over the first three quarters, click the link below.

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