With third quarter GDP being reported next Wednesday – less than a week before election day – the US is still not in recession.

Yes, monetary policy has been tight, but the lags between tighter money and the economy are long and variable.  In addition, massive budget deficits continue to provide incomes for a wide range of occupations.  The official figures for Fiscal Year 2024 arrived Friday afternoon (isn’t it just like the government to announce bad news right before the weekend!) and the deficit was $1.832 trillion, or what we estimate to be 6.4% of GDP.  That’s the second straight year with a deficit in excess of 6.0% of GDP, in spite of an unemployment rate averaging less than 4.0%.  These deficits, which are unprecedented in size given peacetime and low unemployment, may have temporarily masked the effects of tighter money.

Meanwhile, innovators and entrepreneurs in high-tech industries and elsewhere have been overcoming government obstacles to push the economy forward.  It’s hard to tell how much each factor (government spending or innovation) deserves credit for recent GDP growth, but roughly half of job creation in the past year has been in government and healthcare.

In the meantime, we estimate that Real GDP expanded at a 3.0% annual rate in the third quarter, mostly accounted for by growth in consumer spending.  (This estimate is not yet set in stone; reports on Friday about durable goods and next Tuesday about international trade and inventories might lead to an adjustment.)

Consumption: In spite of tepid auto sales, overall consumer spending continues to rise, possibly because of continued government deficits. We estimate that real consumer spending on goods and services, combined, increased at a 3.5% rate, adding 2.4 points to the real GDP growth rate (3.5 times the consumption share of GDP, which is 68%, equals 2.4).

Business Investment:  We estimate a 1.7% growth rate for business investment, with gains in intellectual property leading the way, while commercial construction declined slightly.  A 1.7% growth rate would add 0.2 points to real GDP growth.  (1.7 times the 14% business investment share of GDP equals 0.2).

Home Building:  Residential construction dropped in the third quarter, hampered by the lingering pain from higher mortgage rates as well as local obstacles to construction.  Home building looks like it contracted at a 5.0% rate, which would subtract 0.2 points from real GDP growth.  (-5.0 times the 4% residential construction share of GDP equals -0.2).

Government:  Only direct government purchases of goods and services (not transfer payments) count when calculating GDP.  We estimate these purchases were up at a 1.8% rate in Q3, which would add 0.3 points to the GDP growth rate (1.8 times the 17% government purchase share of GDP equals 0.3).

Trade:  Looks like the trade deficit shrank slightly in Q3, as exports and imports both grew but exports grew faster.  We’re projecting net exports will add 0.2 points to real GDP growth.

Inventories:  Inventory accumulation looks like it was slightly faster in Q3 than Q2, translating into what we estimate will be a 0.1 point addition to the growth rate of real GDP.

Add it all up, and we get a 3.0% annual real GDP growth rate for the third quarter.  Not a recession yet, but that doesn’t mean that the US economy is out of the woods.

Brian S. Wesbury – Chief Economist

Robert Stein, CFA – Deputy Chief Economist

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Implications:  Housing starts moderated in September after a big rebound in August.  Looking at the details, the decline in starts was entirely due to a 9.4% drop in the volatile multi-unit category.  Meanwhile, single-family starts rose 2.7% to a five-month high.  Permits for new builds followed a similar tune, as a headline 2.9% drop was completely due to falling permits for multi-unit homes (-8.9%) while single-unit permits ticked up 0.3%.  Starts and permits both seem to be stuck in low-gear and sit at roughly the same levels as 2019.  The same cannot be said for completions.  Despite a 5.7% drop for the month, completions were at the fourth strongest pace since the run-up before the Great Financial Crisis in 2008-09.  With strong completion activity and tepid growth in starts, the total number of homes under construction continues to fall, now down 11.6% since the start of 2024.  That type of decline is usually associated with a housing bust or recession.  The lack of new construction is why home prices have remained elevated while rents are still heading up in much of the country: we are building too few homes while lax enforcement of immigration laws mean rapid population growth.  The home building sector seems strangely slow given our population growth and the ongoing need to scrap older homes due to disasters or for knockdowns. We think government rules and regulations are likely the major hurdle for builders in much of the country, but home construction might also be facing headwinds from a low unemployment rate (which makes it hard to find workers) as well as relatively high mortgage rates.  That said, there are some tailwinds for housing construction, as well.  Many owners of existing homes are hesitant to sell and give up their fixed sub-3% mortgage rates, so many prospective buyers will need new builds.  In addition, Millennials are now the largest living generation in the US and have begun to enter the housing market in force, which represents a demographic tailwind for activity.  Finally, the widely anticipated commencement of the Federal Reserve’s easing began in September with a 50bps cut. As more rate cuts arrive, mortgage rates should trend lower as well, helping put a floor under housing as we close out 2024.   Putting it together, we don’t see housing as a major driver of economic growth in the near term, but we’re not expecting a housing bust like the 2000s on the way, either.

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In this week’s “Three on Thursday,” we explore the latest developments in space exploration. Advancements in space travel technology have dramatically reduced the cost of launching payloads into space. From the iconic Apollo missions of the 1960s to today’s cutting-edge innovations, breakthroughs in materials science and propulsion—driven largely by private companies like SpaceX—have brought down what were once astronomical costs. 

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Implications:  Industrial production gave up ground in September, falling slightly more than expected in what has been a choppy past few months for the sector.  Moreover, data from previous months were revised down, and when included brought the decline to 0.5%. That said, today’s headline looks worse than the details.  The Federal Reserve points out that a strike at a major producer of civilian aircraft held down total IP growth by an estimated 0.3 percent in September, and the effects of two hurricanes subtracted an estimated 0.3 percent, as well.  Manufacturing was the biggest source of weakness, falling 0.4%.  Production in the volatile auto sector dropped 1.6% following an August gain that was the largest since 2021.  Non-auto manufacturing (which we think of as a “core” version of industrial production) posted a more modest decline of 0.3% in September.  The only bright spot in this “core” measure came from production in high-tech equipment which rose 1.5% in September, likely the result of investment in AI as well as the reshoring of semiconductor production.  High-tech manufacturing is up at a 13.8% annualized rate in the past six months and 10.0% in the past year, the fastest for any major category.  The mining sector was also a drag in September, declining 0.6%.  Lower production of oil and gas more than offset a gain in the extraction of other minerals and metals.  Finally, the utilities sector (which is volatile and largely dependent on weather) was the only category that posted an increase in September, rising 0.8%.  In other manufacturing news this morning, the Philadelphia Fed Index, a measure of factory sentiment in that region, rose to +10.3 in September from +1.7 in August. Meanwhile, the Empire State Index, its counterpart for the New York region, fell to -11.9 in September from +11.5 in August.  Finally, on the housing front, the NAHB Housing Index (a measure of homebuilder sentiment) rose to 43 in October from 41 in September.  However, a reading below 50 signals a greater number of builders view conditions as poor versus good.

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Implications:   The US consumer closed out the third quarter on a respectable note as retail sales rose by slightly more than expected in September and the underlying details of the report were solid.  Sales rose 0.4% in September versus a consensus expected rise of 0.3%, while revisions to previous months’ activity pushed the overall gain to 0.5%.  The monthly advance was broad-based with ten out of thirteen major sales categories rising, led by a 1.0% increase for sales at restaurants and bars, the largest increase for that category in 2024.  Last month’s activity in this category was revised higher too, now showing a 0.5% increase versus an initial reading of no change.  Sales in this category are up a solid 3.7% in the last year, but much lower than the 10.1% advance in the year ending in September 2023.   We will be watching this category closely since it is the only glimpse we get at services in the retail sales report, which have been an important driver of economic growth the last couple of years as consumers have shifted their preferences back toward a more normal mix of goods and services after the COVID years.  Looking at the other details of the report, the largest decline was at gas stations (-1.6%) as gas prices fell in September.  Stripping this out along with the other often-volatile categories for autos and building materials, “core” sales jumped 0.8% in September and were up 1.0% when factoring in revisions.  These sales – which are crucial for estimating GDP – were up at a 6.2% annualized rate in the third quarter versus the second quarter average.  Notably, while overall sales are up only 1.7% in the past year, core sales are up a more respectable 3.9%.  What does the report mean for investors?  The Fed is much more likely to cut rates by a quarter point the day after the election, not a half.  In other news this morning, initial jobless claims fell 19,000 last week to 241,000 after hitting a recent high of 260,000 the week prior.  Meanwhile, continuing claims rose 9,000 to 1.867 million.  On the trade front, import prices declined 0.4% in September while export prices fell 0.7%.  In the past year, import prices are down 0.1% while export prices are down 2.1%.

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There are two types of economists in the world…demand-siders and supply-siders.  Without digging too deeply, one huge difference shows up in government policy.  Supply-siders want low tax rates, high savings rates (and investment), and minimal regulation.  Why? Because wealth and higher living standards come from entrepreneurship and invention – i.e. Supply.

Demand-siders think the way to boost growth is to boost “Demand.”  John Maynard Keynes is the father of modern demand-side thought, arguing that if the pace of economic growth is too slow the government can step in to “stimulate demand” by running or expanding a government deficit.

A tenet of Keynesianism is that growth is best achieved by taxing money from those with higher incomes because they have a “higher propensity to save,” and giving it to those with lower incomes because they have a “higher propensity to consume.”

No wonder politicians love Keynes.  It’s an economic theory that sanctions giving taxpayer resources directly to people under the theory that this will boost overall economic growth.  At least in the short run according to the Keynesians – less economic growth and fewer jobs are worse than deficits.  (And the long run doesn’t matter, they say, because we’ll all be dead, anyhow.)

The policy response to both the Financial Crisis and COVID was Keynesianism on steroids.  Clearly, politicians of both parties have rallied behind the Keynesian flag in the past 16 years. As Richard Nixon once said,“We are all Keynesians now.”

Nixon may have been right if we apply that statement to politicians.  But Friedman, Hazlitt, Mises, Hayek, and others continually pointed out the damage from this short-term, demand-side thinking would be immense and the stagflation of the 1970s proved them right and the politicians wrong.  Like then, we think we have reached “peak Keynesianism” again!

The fiscal well is now running dry.  The federal budget deficit was 6.2% of GDP in Fiscal Year 2023 and came in about 6.4% of GDP in FY 2024, which ended two weeks ago. To put this in perspective, the US did not run a budget deficit of more than 6.0% of GDP for any year from 1947 until the Great Recession and Financial Panic of 2008-09.  Not during the Korean War, not during the Vietnam War, not during the Cold War.  But now we did it two years in a row without a war and with the unemployment rate averaging 3.8%.

These deficits were made possible, in a large way, by having the Federal Reserve monetize the debt.  At the same time the Fed held interest rates artificially low, meaning the actual cost of these deficits was masked.  But, like the 1970s, inflation appeared due to easy money and now interest rates are up.  The interest on the national debt has soared from a modest 1.5% of GDP in FY 2021 to what is likely 3.0% of GDP in FY 2024.

This means that if we hit a recession anytime soon, policymakers will find it very hard to rely on a Keynesian response.  Deficits and interest payments are already too high!

At the same time, a Keynesian-motivated redistribution scheme to try to boost spending also faces a major hurdle.  The personal saving rate – the share of after-tax personal income that is not consumed – was 4.8% in August.  That’s well below the 7.3% average in 2019, prior to COVID, and less than half the savings rate of 12% that the US had in 1965.  What this means is that trying to boost consumer spending by taking from Penelope to pay Paul will probably not work, either.  

Put it all together and it looks like the traditional tools Keynesians like to use when economic troubles hit will not be available if the US runs into economic trouble.  We see it everywhere.  Evidently, the Secret Service, FEMA, and border security all need more money.

The system has reached Peak Keynesianism.  Like the late 1970s and early 1980s, it is time to change course.  The good news is that because of democracy, this can happen any time. 

Brian S. Wesbury – Chief Economist

Robert Stein, CFA – Deputy Chief Economist

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Implications:   Producer prices were unchanged in September.  While the Fed will probably cut interest rates in November, it is not at all clear that inflation problems are fully behind us.  It should be noted that energy prices have played an outsized role in the slower inflation readings of late, and stripping out this volatile component shows the Federal Reserve still has some work to do.  Nevertheless, the Fed looks nearly certain to cut rates by 0.25% when they meet again immediately following Election Day.  With the flat reading in September, producer prices are up 1.8% in the past year.  But when you strip out energy as well as food prices – the other historically volatile category – “core” producer prices rose 0.2% in September and are up 2.8% in the past year, a faster pace than the 2.3% reading for the twelve months ending September 2023.  Diving into the details of today’s report shows service prices lead the core index higher, rising 0.2% in September and up 3.1% in the past year.  The September increase in services was broad based, with all major categories showing higher prices. Prices for goods declined 0.2% in September and are down 1.1% from a year ago.  Within goods, rising costs for motor vehicles, chicken, and electric power were more than offset by a 5.6% decline in gasoline prices (which should reverse and show a rise in October with energy prices up more than 10% so far this month).  Further back in the supply chain, prices in September declined 0.8% for intermediate demand processed goods and fell 3.2% for unprocessed goods.  The direction of inflation moving forward is very likely to be dictated by 1) the services side of the economy, which suffered heavily during the COVID shutdowns but has since returned to the forefront and 2) changes in the money supply, which, after surging in 2020-21, peaked in early 2022. Although the M2 measure of money has been rising gradually since last October, it’s still down 2.5% from the peak in April 2022. Too little growth in the money supply means continued downward pressure on both inflation and economic growth.  We will be watching the path of M2 growth closely as the Fed continues cutting rates. A sharp resurgence in M2 growth would bring with it the risk of accelerating inflation. Does the Fed have the patience to ease at a slow and steady pace, or will they overreact at signs of economic trouble? Only time will tell, but the stakes are high and the Fed’s record is less than pristine.

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With the Presidential Election fast approaching, conversations about the wealthy not paying their “fair share” of taxes have become more frequent. Figures like Warren Buffett are often cited, with examples showing he pays a lower tax rate than many of his office colleagues. For some, this serves as proof of a tax system that isn’t progressive enough. But what do the actual data tell us? Are the wealthy really contributing less than their fair share, as some claim? And did the 2017 tax cuts only benefit the rich? In this week’s edition of “Three on Thursday,” we delve into the most recent IRS tax data from 2021 to provide a clearer picture of the federal income tax landscape. 

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Implications:   Inflation progress stalled in September as both headline and core inflation came in hotter than expected.  Headline prices rose 0.2% versus a consensus expected 0.1%, while the twelve-month reading ticked down to 2.4%.  That’s the sixth consecutive month where the year-to-year reading has declined, but it’s worth noting that lately inflation has been held down by declining energy prices, which fell 1.9% in September and are down at a 10.6% annualized pace in the last six months.  This may not last, as oil prices are up about 10% in the first two weeks of October, mostly due to increased tensions in the Middle East.  “Core” prices, which strip out food and energy, rose 0.3% in September versus a consensus expected 0.2%, while the year-ago comparison increased to 3.3%, the highest level in four months. The main driver of core inflation has been housing rents, which rose 0.4% and have shown little to no sign of slowing.  Some analysts – including those at the Fed – have argued that housing rents have artificially boosted the inflation picture due to the way it’s measured and the lags at which those changes are reflected in the monthly reports.  But a subset category of prices the Fed used to tell investors to watch closely but no longer seems to mention – known as the “Supercore” – which excludes food, energy, other goods, and housing rents, rose 0.4% in September and are up 4.3% in the last year, worse than the 3.8% reading in the year ending in September 2023.  No matter which way you cut it, inflation is still running above the Fed’s 2.0% target, now for the 43rd consecutive month.  We have said for some time that easing in inflation will come should the Fed have the resolve to let the lagged effects of tighter monetary policy do its work.  Recent economic data suggest the Fed is much more likely to cut rates by a quarter point the day after the election, not a half.  In other news this morning, initial jobless claims rose 33,000 last week to 258,000, the highest level for any week this year, at least in part influenced by Hurricane Helene and potential secondary effects from the temporary dockworkers strike.  Meanwhile, continuing claims rose 42,000 to 1.861 million.

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