Implications:  The manufacturing sector took a turn for the worse in March, with the ISM Manufacturing index falling back below 50.0 to 49.0, the first contractionary reading this year.  It’s important to remember that before 2025, the manufacturing sector had been limping along the last two years: the ISM index was below 50 every single month for 2023-24.  Now, manufacturers will also have to contend with uncertainty surrounding tariffs (whether they are actually put in place or not, and to what degree), and the resulting changes in supply chains.  That impact was clearly seen in the March data.  Looking at the details of the report, all major measures of activity moved lower.  Leading the decline was the index for new orders, falling from 48.6 to 45.2, the lowest level since May 2023. A respondent comment from the Computer & Electronic Products industry noted that customers have begun pulling orders due to anxiety about continued tariffs and pricing pressures.  Meanwhile, production retreated, falling from 50.7 to 48.3 (a four-month low) as companies revise their production plans downward.  On the hiring front, companies continue to reduce headcounts through layoffs and hiring freezes.  The employment index declined to 44.7, with just one out of eighteen industries (Primary Metals) reporting higher employment in March, versus seven that reported a decline.  Finally, the worst part of the report is that inflation remains a major problem.  Prices paid by companies rose again in March and the pace accelerated, with the index jumping to 69.4. That is the highest index level since the surging inflation of 2022, even as manufacturing stagnates.  Not a good sign for the economy.  We hope the Federal Reserve has the resolve to stomp the embers of inflation out, despite the short-term economic pain that may result from federal policy changes – pain that will ultimately pave the way for long-term growth.  In other news this morning, construction spending rose 0.7% in March, led by a large increase in homebuilding as well as highway & street and commercial projects.

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During the ten years prior to COVID, PCE inflation, the Fed’s preferred measure, averaged about 1.5% per year.  Jerome Powell said it was too low and he wanted inflation to “average” 2% over time.  Well, he got his wish, and more.  PCE inflation has averaged 3.7% in the past five years and 2.6% over the past ten years.

In other words, because of its misguided policies during COVID, the Fed has pushed inflation above both its short-term and long-term target.  Any apparent success at bringing it back down appears to be “transitory.”

In the past 12 months, PCE prices are up 2.5%, barely better than the 2.6% gain in the year ending in February 2024 in spite of the Fed thinking that monetary policy is currently restrictive or tight.  Core PCE prices are up 2.8% in the past year versus 2.9% in the year ending February 2024.

Some investors might still think this is due to the lags associated with housing rents, but the Fed developed a measure a few years ago called the SuperCore, which excludes food, energy, other goods, and housing rents, and that measure of prices is up 3.3% in the past year.  No wonder the Fed doesn’t mention it anymore.

It's not tariffs that concern us.  They may boost some prices, but they also reduce demand of other goods and services.  So, why are we pessimistic about the Fed keeping inflation persistently at 2.0% or below?  Because ultimately inflation is a monetary phenomenon and the consensus among economists in favor of low inflation has broken down.

Back in the 1990s and early 2000s, both liberal and conservative economists generally agreed that low inflation was better – it should be low enough that it wasn’t a factor in business decisions.  Now, with debt levels so high, and the stock market addicted to easy money, higher inflation has some benefits to policymakers even if it comes with some downside.

One of the problems is that the Fed is still fixated on where it sets the level of short-term interest rates rather than paying attention to the M2 measure of the money supply.  That measure was up almost 4.0% in February from a year ago – a moderate pace – but may have accelerated since the last report, with the Treasury General Account in March 2025 down about $400 billion versus the February 2024 average.

Think of that account, the TGA, as the federal government’s checking account.  When the balance in that account goes up, the Treasury Department is pulling cash from the banking system and effectively extinguishing part of the money supply.  But now, with the balance in that account declining, that cash is being converted back into M2.

In the meantime, we suspect that the Fed will soon come under increasing political pressure for more rate cuts and less quantitative tightening (QT) regardless of economic conditions. And the next Fed chairman – Powell’s term as chairman ends in about a year – will have to pledge to be more flexible about rate cuts and quantitative tightening to secure his nomination.

The bond and gold markets seem to understand this.  Gold has jumped to over $3,000/oz and the 10-year Treasury yield is still over 4%.  With this yield, our capitalized profits model says stocks are still overvalued.  Moreover, while many think Fed rate cuts would bring down longer-term yields, the market seems to be saying “no.”  The bond market vigilantes are more worried about debt levels and inflation than policymakers.

Brian S. Wesbury – Chief Economist

Robert Stein, CFA – Deputy Chief Economist

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Implications:  Personal income is off to a hot start in 2025, jumping 0.8% in February following a strong 0.7% rise in January.  Unfortunately the gains are largely being driven by government transfers.  In January, this was due to cost-of-living adjustments to Social Security benefits; in February it was premium tax credits for health insurance purchased through the Health Insurance Marketplace (Obamacare).  Government benefit payments to individuals are up 7.9% in the past year; excluding COVID, that’s near the largest 12-month increase in more than a decade.  At the same time, pay in the public sector rose 0.4% in February and is up 5.8% in the past year, versus private-sector wages and salaries, which were up 0.5% in February but up a more modest 3.2% in the past year.  We don’t think the growth in government pay – or massive government deficit spending – is either sustainable or good for the US economy, which is why we’re hoping policy changes in DC represent a shift in thinking on the growth of government.  Long term, it’s the growth in private-sector earnings that would better sustain the economy.  Personal consumption, meanwhile, rose 0.4% in February, but that was largely the result of inflation.  “Real” consumption rose just 0.1% in February following a 0.6% decline in January and should be roughly unchanged for Q1 versus Q4.  In nominal terms, spending on goods increased 0.9% in February and is up 4.0% from a year ago, while spending on services rose 0.2% in February and is up a strong 5.9% in the past year.  On the inflation front, PCE prices increased 0.3% in February and are up 2.5% in the past year.  That’s very close to the 2.6% increase in the year ending February 2024, which means the Fed has made almost no progress in the inflation flight in the past year.  “Core” prices (which exclude food and energy) rose 0.4% in February and are up 2.8% versus a year ago.  Some analysts claim official inflation figures are running too high because of rents, but the “SuperCore” version of PCE prices, which excludes all goods, energy services, and rents, is up 3.3% in the past year, even worse than headline inflation.  The Fed last week reiterated plans to be patient on any further rate cuts as they watch how the economy responds to actions out of DC, but risks remain that any signs of economic weakness – as the pain of reform is felt before the economic gain – could translate to an overreaction from the Fed that risks pushing inflation higher.  In other recent news, pending home sales, which are contracts on existing homes, rose 2.0% in February following a 4.6% decline in January, suggesting a modest decline in existing home sales (counted at closing) in March. On the manufacturing front, the Kansas City Fed Manufacturing Index, a measure of factory sentiment in that region, rose to a still negative -2 in March from -5 in February.

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In this week’s edition of “Three on Thursday,” we look at the Federal Reserve’s financials through year-end 2024. Back in 2008, the Federal Reserve embarked on a novel experiment in monetary policy by transitioning from a “scarce reserve” system to one characterized by “abundant reserves.” In addition to inflation, this experiment has resulted in some other developments that are worrisome. 

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Implications:   Hold off on GDP itself for a moment.  The most important part of this morning’s report was on economy-wide corporate profits, which grew 5.4% in the fourth quarter vs. the third quarter and are up 6.9% from a year ago.  The best news was that profits in all major areas were up. Profits from domestic non-financial industries grew 2.0%, while profits from domestic financial firms grew 10.7%. Profits from the rest of the world increased by 18.8% for the quarter.  Financial industry data include the Federal Reserve (either profits, or losses) and because the Fed pays private banks interest on reserves, and has raised interest rates, it has been generating unprecedented losses in recent quarters.  Excluding the losses at the Fed (because we want to accurately count profits in the private sector), overall corporate profits were up 4.1% in the fourth quarter and up 5.5% from a year ago.  However, plugging in non-Fed profits into our Capitalized Profits Model suggests stocks remain overvalued. Looking at the other details of today’s report, the final reading for real GDP growth in the fourth quarter was revised slightly higher from last month’s estimate, coming in at a 2.4% annual rate, but the underlying components showed a slightly weaker mix. Downward revisions in consumer spending (specifically services) offset a larger increase in net exports, and other small increases in business investment (mainly structures), home building, and government purchases. For a more accurate measure of sustainable growth, we focus on "core" GDP, which includes consumer spending, business fixed investment, and home building, but excludes the more volatile categories like government purchases, inventories, and international trade. "Core" GDP grew at a 2.9% annual rate in Q4, slightly lower than last month’s prior estimate of +3.0%. Today we also got Q4 Real Gross Domestic Income (GDI), an alternative measure of economic activity.  Real GDI was up at a 4.5% annual rate in Q4 and up 2.7% from a year ago.  GDP inflation was revised slightly lower to a 2.3% annual rate in Q4, and is up 2.5% over the past year, both still higher than the Fed’s 2.0% target.  Meanwhile, nominal GDP (real growth plus inflation) increased at a 4.8% annual rate in Q4 and is up 5.0% year-over-year. A 5.0% trend growth rate in nominal GDP suggests the Fed should be reluctant to cut rates in the near future.  On the labor front this morning, initial jobless claims declined 1,000 last week to 224,000. Meanwhile, continuing claims declined 25,000 to 1.881 million.  These figures are consistent with continued job growth in March.

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Implications:  New orders for durable goods surprised to the upside in February, rising 0.9% following a 3.3% jump in January.  That comfortably outpaced the consensus expected 1.0% decline, while prior months data were revised slightly upward as well. Transportation led activity higher in February, with orders for autos rising 4.0% – the largest monthly gain in nearly three years – and defense aircraft orders up 9.3%.  Orders for commercial aircraft fell 5.0% in February but that comes following a 92.9% surge in January.  Clearly, transportation orders can swing wildly from month to month, particularly as aircraft orders tend to come in chunks rather than steadily over time, and the potential timing of orders at the start of 2025 to front-run expected tariffs may be further clouding the data.    Excluding the transportation sector, orders for durable goods rose 0.7% in February (+0.8% when including revisions to prior months), with orders higher across most major categories.  Orders were led higher by primary metals (+1.2%), while fabricated metal products (+0.9%), and electrical equipment (+2.0%) also showed healthy order growth.  Computers and electronic product orders were unchanged in February.  The most important number in the release, core shipments – a key input for business investment in the calculation of GDP – rose 0.9% in February.  If unchanged in March, these orders would be up at a 2.7% annualized rate in Q1 versus the Q4 average.  But while core shipments rose in February, orders for these items fell for the first time since October, which likely reflects a pause in investment plans from businesses as they figure out where policy out of D.C. is headed in the months ahead.  With the Trump Administration back in Washington with a mandate to cut taxes, regulations, and the size of government, we expect volatility in the data to continue as businesses navigate the new policy environment and how that may change the outlook for investment and growth.  In turn, the Federal Reserve will navigate what these changes mean for the path of inflation.  There is plenty of potential for both progress and payback in 2025, but policy makers must decide if they are willing to take the uncomfortable steps towards needed reform, or if they will default to the more comfortable – but far less sustainable – path of large deficit spending that has unfortunately become the norm.  In other recent news, the M2 measure of the money supply grew 0.4% in February, partly because the Treasury Department is draining the Treasury General Account, which was near $800 billion a year ago and is now down to roughly $400 billion.  In other words, the 3.9% growth in M2 from a year ago is partly due to the Treasury putting money back into the economy.  The Fed and Treasury must be careful.

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Implications:  New home sales posted a modest gain in February, rebounding from their drop in January.  Looking at the big picture, buyers purchased 676,000 homes at an annual rate, well below the highs of the pandemic and essentially unchanged from 2019.  Moreover, the rebound in homes sales in February did not fully offset the weather, and fire, related weakness in January, and sales were still lower than their pace in the last quarter of 2024. Though we expect a modest upward trend in sales in 2025, the housing market continues to face challenges. The biggest (and most obvious) is financing costs. The good news is that thirty-year fixed mortgage rates have come down recently, falling below 7%.  However, that is still above where mortgage rates were when the Fed started cutting interest rates in September of last year. Further, the Fed has had to pause their rate cuts due to sticky inflation, meaning the housing market is on its own for the time being. One piece of good news for potential buyers is that median sales prices are down 1.5% in the past year, and down 10% from the peak in October 2022. The Census Bureau reports that from Q3 2022 to Q4 2024 (the most recent data available) the median square footage for new single-family homes built fell 3.4%. So, it looks like at least part of the drop in median prices is due to a lower price per square foot, along with the mix of homes on the market including smaller properties.  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 over 280% versus the bottom in 2022. This contrasts with the market for existing homes which continues to struggle with an inventory problem, often due to the difficulty of convincing current homeowners to give up the low fixed-rate mortgages they locked-in during the pandemic.  While the future cost of financing remains a question, lower priced options and an abundance of inventories will help fuel new home sales in 2025. In other recent housing news, the national Case-Shiller index rose 0.6% in January and is up 4.1% from a year ago.  Meanwhile, the FHFA index rose 0.2% in January and is up 4.8% from a year ago. Finally, on the manufacturing front, the Richmond Fed index, a measure of mid-Atlantic factory activity, fell to -4 in March from a reading of +6 in February.

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In spite of severe polarization on so many issues, there is at least one thing that Americans agree on across the entire political spectrum, left, right, and center.  That is: At some point in the past sixty years, or so, something major went wrong with the US economy and it is still causing problems today.

What are those problems?  Different political tribes, and their respective economists and commentators, may explain it differently, but they generally agree that economic growth and productivity increases are too slow, the distribution of income is too skewed toward the upscale, housing is unaffordable, and there is too little manufacturing in the US.

The left often blames “greed” and “capitalism,” or maybe just “late capitalism,” and proposes to raise taxes on the rich.  If you listen closely, they argue that capitalism’s worst evil is that it causes “climate change,” which just makes every other problem worse.  They want higher tax rates on regular income and investment income, and even talk of a wealth tax on unrealized capital gains.  Then, by redistributing that money to the appropriate people and places, the US could fix all the economic problems that confront it.

On much of the political right there is a different narrative, which was recently expressed in depth by former US Trade Representative Robert Lighthizer in an interview with Tucker Carlson.  In his telling, the movement toward freer world trade over the past forty or fifty years, what he calls “hyper-globalization,” is at the root of many economic and social problems.

As manufacturing went global, the fabric of the US changed.  Not only did the US economy slow, but the structure of the country changed.  He argues that many places have lost their sense of community, compared to the immediate post-World War II era in which rich, poor, and middle class, often lived in the same towns.

His argument is bolstered by the data.  Industrial production data show that manufacturing has grown just 4.3% in the past twenty-five years.  Not 4.3% annualized, we mean 4.3% total.  This translates to 0.2% annualized growth.  In some cases, entire industries are uncompetitive without large government contracts, like shipbuilding.

Both narratives, in our opinion, are trying to deal with the symptoms of the underlying problem, not the problem itself.  This is similar to the argument that our food supply makes us less healthy (obesity, diabetes, compromised immune systems).  By treating these symptoms, we are ignoring the root cause.

There is an “elephant in the room” and almost no one incorporates it into their analysis.  That elephant is the massive growth in the size and scope of the federal government.  Excluding defense (in order to understand the impact of the bureaucracy and redistribution) federal government spending was 7% of GDP in the 1950s.  That rose to 10% in the 1960s and then 14% in the 1970s.  It stabilized there between 1980 and 2000, but then started growing again.  So far in the 2020s, non-defense government spending has averaged 23% of GDP, more than triple its size in the 1950s.

Every dime the government spends is taken from the private sector, so the bigger the government gets, the smaller the private sector becomes.  Adding all government spending – federal, state and local – with the cost of regulation, and government directs or prevents more than 50% of all output.  No wonder saving rates are low, houses are unaffordable, manufacturing has moved, and economic growth rates have stumbled.

In many respects we have already abandoned capitalism.  Abandoning it harder, or moving toward protectionism, is not the real answer.  We believe shrinking the size of government itself would fix most of our problems, certainly the economic ones.

There is enormous upside potential (long-term, not short term) if DOGE helps the federal government get its fiscal house in order and downsizes government spending.  Yes, we know it’s disruptive in the near term, but this is the kind of disruption that deals with the major cause of our problems, not just the symptoms.

Brian S. Wesbury – Chief Economist

Robert Stein, CFA – Deputy Chief Economist

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Implications:  Existing home sales surprised to the upside in February, rebounding a healthy 4.2%. Sales activity has been characterized by fits and starts since 2022, with any positive upward trend eventually running into a ceiling of around 4.300 million.  While the 4.260 million pace of February is getting close to that apparent ceiling, it’s important to remember that it is still well below the roughly 5.250 million annual pace that existed pre-COVID, let alone the 6.500 million pace during COVID.  One problem recently is that lower interest rates from the Federal Reserve (who have since paused rate cuts) haven’t translated into lower 30-year fixed mortgage rates, which remain near 7%. So at least so far, the widely anticipated shot in the arm to the housing market from improved affordability hasn’t happened and most buyers continue to sit on the fence. Meanwhile, home prices are rising again with the median price of an existing home up 3.8% from a year ago. Speaking of price, it looks like the housing market has bifurcated.  While the sales of homes worth $750,000 and above are up in the past year, sales for homes below this threshold have continued to fall.  On a positive note this demonstrates that, at least at the higher end of the market, both buyers and sellers are beginning to adjust to the new reality of higher rates.  However, it also suggests that at the lower end of the price spectrum inflation has priced many Americans out of the existing home market.  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. Finally, 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 a major impediment to activity by limiting future existing sales (and inventories).  However, there are signs of progress with inventories rising 17.0% in the past year.  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 3.5 in February, a considerable improvement versus the past few years, but still below the benchmark of 5.0 that the National Association of Realtors uses to denote a normal market.   A tight inventory of existing homes means that while the pace of sales looks like 2008, we aren’t seeing that translate to a big decline in prices.  In other recent news on the labor market, initial jobless claims rose 3,000 last week to 223,000, while continuing claims increased 22,000 to 1.892 million.  These figures are consistent with continued job growth in March, but at a slower pace than in 2024.  Finally, the Philadelphia Fed Manufacturing Index, a measure of factory sentiment in that region, fell to a still healthy 12.5 in March from 18.1 in February.

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With a renewed focus on protecting American industries and generating additional revenue, President Trump’s administration has intensified its tariff policies. These measures could have a significant impact on overall U.S. growth and revenue, but their impact varies widely across different states. In this edition of “Three on Thursday,” we examine the largest import partners for each U.S. state, identify their top export markets, and analyze the role of trade as a share of state GDP. 

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