To say the least, since its inception in 1913, the Federal Reserve has had its ups and downs.  One thing most people don’t know is that prior to the invention of the Fed, other than during wars, there was almost no inflation. Various sources including the Federal Reserve regional banks show the purchasing power of $1 in 1900 was the same as or higher than it was in 1800.

The Government did print and borrow money during wartime, which caused inflation during the War of 1812 and the Civil War.  In between wars, when the US was often on a gold standard, the economy experienced deflation.

A gold standard basically keeps the money supply stable, but technology increases the production of goods and services, so if we don’t print more money, the average dollar price of things falls.  More goods chasing the same amount of dollars creates deflation (actually “good” deflation).

Since 1913 (and the invention of the Fed), the US has experienced cumulative inflation of 3,297%.  A massive difference when compared to the 1800s.  Moreover, as Milton Friedman proved, it was Fed mistakes with monetary policy that caused the Great Depression.  Then, in the 1960s and 1970s, because the Fed printed too much money the US experienced double digit inflation.

Paul Volcker took over the Fed in 1979 and fixed the Fed’s inflation problem but ended up causing two sharp recessions during that process.  Alan Greenspan followed Volcker and, from 1985 to 1998, the Fed ran spectacularly good monetary policy.  Then it tightened too much in 1999 and then loosened too much during the dot.com crash.  Excessively low rates from 2000-2005 caused a housing bubble which eventually became the Great Financial Crisis.

In our opinion, the Fed’s reaction to that crisis (printing trillions of dollars with Quantitative Easing) was a huge mistake.  The Fed followed it up with even more QE during COVID, and that easy money caused the worst inflation since the 1970s.

Like we said, the Fed has had its ups and downs.  One thing we don’t think enough people think, or talk, about is how much QE has changed our banking system and monetary policy.  We’ve written about it frequently.

To summarize it in a nutshell: It is a myth that QE saved the economy in 2008.  We started QE in September and passed TARP in October 2008.  The S&P 500 fell an additional 40% in the next six months.  When we ended overly strict mark-to-market accounting in March 2009, the economy and market both bottomed.

What QE did was flood the banks with reserves as the Federal Reserve grew its balance sheet massively.  So, instead of selling bonds into a free market, the Treasury sold them at interest rates well below inflation because the Fed was buying them.  This money ended up as deposits in banks.

In order to keep that money contained, the Fed increased capital requirements and liquidity rules on banks to absurd levels.  The Fed also paid banks to hold those reserves.  In other words, the Fed took the risk of owning Treasury debt and mortgage-backed securities while banks held risk free reserves.

During QE 1,2&3 those reserves stayed contained and did not cause inflation.  But when Jerome Powell did QE during COVID, he reduced liquidity rules and M2 grew 42%...it was the easiest forecast of inflation we have ever made.  The crazy thing is that Powell won’t talk about M2…reporters won’t ask about it at his press conferences because he just denies that there is any relationship.  He still blames supply chains for inflation.

More importantly, the Fed’s QE has created income inequality and a divide between the young and the old.  Because capitalism is often blamed for inequality, it’s no wonder almost 2/3rds of Americans under 30 have a “favorable view” of socialism.

So when J. Powell complains about threats to Fed Independence, can he actually understand that Fed policy has influenced politics more than any other time in history?  Tripling the money supply in 18 years is massive interference in economic activity and it impacts the political world.

We want an Independent Fed, but what the Fed has done has complicated that.  And now with Powell not leaving the Fed, he is doubling down on his mistakes.  He should go.  Let Kevin Warsh take over.  And move to unwind QE.

Fed policy in the next few months will be interesting.  The market is actually pricing in a rate hike, mainly because the CPI and PPI both exceeded consensus last month.  However, the money supply is still growing relatively slowly and housing prices are growing only 1% YOY.  In other words current inflation is likely influenced by Iran, not the money supply.   We still think it is more contained than the market thinks.  

Kevin Warsh apparently wants to do QT and cut interest rates at the same time.  We are not sure this is a wise policy to follow, however, at least it is a change from what we have been doing lately.  It’s time to make the Fed great again…that means following a different path.  And we certainly hope Kevin Warsh is the chair to do that.  Powell certainly wasn’t.

Brian S. Wesbury – Chief Economist

Robert Stein, CFA – Deputy Chief Economist

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Implications: Industrial production surprised to the upside in April, beating even the most optimistic forecast of any economics group surveyed by Bloomberg.  Overall activity rose 0.7%, with underlying details showing broad-based gains.  The largest positive contribution in April came from the manufacturing sector, which posted a gain of 0.6%. The volatile auto sector rebounded in April, with activity jumping 3.7%.  Meanwhile, manufacturing ex-autos (which we think of as a “core” version of industrial production) rose 0.3%, a fourth consecutive monthly gain. The typical bright spots in the “core” measure were present in today’s report as well.  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 1.0% in April.  High-tech manufacturing is up a strong 9.2% in the past year, the fastest 12-month growth rate of any major category. Meanwhile, manufacturing of business equipment rose 1.5% in April and was up 6.0% in the past year, signaling a broader reindustrialization. Utilities output (which is volatile and largely dependent on weather from month to month) also posted a gain of 1.9%. Notably, this series has been on an upward trend since 2023 following nearly 20 years of stagnation as power hungry data centers have boosted demand for US power generation. Finally, the one weak spot in today’s report came from the mining sector, which posted a decline of 0.1%.  A drop in the drilling of new wells more than offset unchanged oil and gas production and a small gain in the extraction of other metals and minerals in April. So far, we still haven’t seen US energy companies boost production significantly in response to higher prices caused by the Iran War. Finally, in other news this morning, the Empire State Index – a measure of factory sentiment in the New York region – increased to +19.6 in May from +11.0 in April.

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In this week’s edition of “Three on Thursday,” we take a deeper look at the unemployment rate in the U.S., how it’s calculated, and why it matters. Every month, usually on the first Friday, the Bureau of Labor Statistics reports jobs data coming from two surveys of establishments and households. Today we will be focusing solely on the Household survey. To find out more, click the link below.

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Implications:  Despite higher inflation consumer spending remained strong in April.  Retail sales rose 0.5% for the month, matching consensus expectations, and were revised higher for prior months.  Yes, the gain in April was fueled by another large jump at gasoline stations (+2.8%) as national gas prices moved to their highest level since 2022.  However, gains were broad-based with nine out of thirteen major sales categories rising for the month.  The largest exception was in the autos category, which slipped 0.4% in April. We like to follow “core” sales, which strip out the volatile categories for autos, building materials, and gas stations and is important for estimating GDP.  This measure rose 0.5% in April and were up 0.8% when including revisions to earlier months. The largest increase in the core grouping once again came from nonstore retailers (think internet and mail-order) which rose 1.1% in April, the third gain above 1.0% in the past four months.  Sales in this category are up 11.1% in the past year, among the highest of any core category. Sales at clothing stores and furniture stores were the lone core categories to decline in April, falling 1.5% and 2.0%, respectively. Meanwhile, the category for restaurants & bars – the only glimpse we get at services in this report – rose 0.6% in April but are up only 2.7% in the last year, lagging overall sales.  Nominal retail sales have risen 4.9% in the past year, but it’s important to remember the impact inflation has on these figures.  “Real” inflation-adjusted sales are up just 1.1% in the past twelve months and still down from their peak in April 2022.  No growth in four years.  So despite the solid report in April, the broader picture remains soft.  Keep in mind that higher than normal tax refunds may be temporarily boosting the spending power of consumers, too.  In the meantime, expect continued volatility in this report as the war with Iran evolves.  In employment news this morning, initial jobless claims rose 12,000 last week to 211,000; continuing claims increased 24,000 to 1.782 million. In other news, import prices jumped 1.9% in April while export prices surged 3.3%, both the highest monthly increases since 2022.  In the past year, import prices are up 4.2%, while export prices have risen 8.8%.

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Implications: The producer price index rose at the fastest pace in more than four years as the ongoing conflict in the Middle East pushed energy prices higher in April. But inflation pressures proved more broad based than just oil.  While energy prices jumped 7.8% led by a 15.6% surge in the cost of gasoline, and food prices rose a more modest 0.2%, producer prices excluding these two typically volatile categories rose 1.0%, also the largest move since early 2022.  In fact, more than half of the April increase in producer prices came from services, which rose 1.2% led by final demand trade services, which measures the margins received by wholesalers and retailers.  Transportation and warehousing services – which are impacted by higher fuel costs which companies are passing along to customers – also showed a notable rise in April.  On the goods side, energy represented more than three-quarters of the 2.0% monthly jump in prices.  Further back in the supply chain, prices for unprocessed and processed intermediate goods rose 4.1% and 2.7% respectively.  Here price pressures were overwhelmingly led by energy processing.  If the Iran conflict ends sooner rather than later – and if that brings a return toward oil prices where they were back in February – inflation pressures should ease in the later parts of 2026.  Until then, incoming Fed Chair Kevin Warsh and the FOMC are unlikely to do anything with rates.  Instead, his early days are likely to be distracted by how to handle current Chair Jerome Powell (his term as chairman ends this Friday) who announced that he will remain on the Fed Board of Governors, which means he will retain a seat as a voting member on the FOMC.  That leaves Warsh as a chairman in name only, and any plans to shrink the size of the Fed’s balance sheet will be on the back burner.  We expect volatility and uncertainty to continue in the months ahead as the ongoing conflict in Iran puts pressure on oil prices and disrupts global supply chains. However, sustained movements in overall inflation are led by the money supply, which is up 4.6% 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, leaving room for rate cuts to restart at some point once the conflict in the Middle East dies down.

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Implications:  The conflict in the Middle East is still temporarily boosting measured inflation.  Price increases once again came in very high but as expected in April, with the Consumer Price Index rising 0.6% following a 0.9% increase in March.  The “core” CPI, which excludes food and energy, rose 0.4% on April, above the consensus expected +0.3%.  The difference between headline and core inflation came from energy, with prices rising sharply (+3.8%) for the second month in a row after the outbreak of war in Iran sent global oil prices sharply higher.  Energy prices accounted for 40% of the overall monthly increase, which pushed the year-ago comparison for headline inflation to a three-year high of 3.8%.  While we expect the effects of higher energy costs to reverse once the conflict winds down, the timing remains uncertain, leaving the Federal Reserve with little conviction in the near term for monetary policy.  In the meantime, core prices are up 2.8% from a year ago, higher than the 2.6% reading from a month ago, and still well above the Fed’s 2.0% target.  Housing rents (those for actual tenants as well as the imputed rental value of owner-occupied homes) were the main driver of core inflation for the month and have been for the last few years.  Recent data had hinted that rents might be finally starting to turn over, but April told a different story, with rents posting the biggest increase in more than two years (+0.5%), though much of the increase likely reflected a one-off adjustment by the BLS to correct for distortions caused by the government shutdown last fall.  Other notable movers in the core group include rising prices for hotels and airline fare (both +2.8%), as well as apparel (+0.6%), and falling prices for new vehicles (-0.2%) and health insurance (-0.4%).  Outgoing Fed Chair Jerome Powell at one point highlighted “Supercore” inflation – a subset category of prices that excludes food, energy, other goods, and housing rents.  That measure rose 0.5% in April, pushing the twelve-month comparison to 3.3%, an eight-month high.  The worst part of the report was that wages continue to lose ground to inflation, as “real” inflation-adjusted hourly earnings declined 0.5% and are now down 0.3% in the past year.  With the inflation picture highly uncertain in the near term, do not expect a rate change at Warsh’s first meeting as Fed Chair in June.  We in the meantime will be focused 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 may drop faster than most investors expect.

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Implications: Existing home sales continued to struggle in April, eking out a small gain but remaining near the lows of the past several years.  Looking at the big picture, sales remain at roughly the same pace as in the aftermath of the Great Financial Crisis and are 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 war on Iran raising energy costs and having an upward impact on inflation.  The result has been a rapid increase in 30-year mortgage rates, which now sit around 6.4%. Higher inflation also takes further rate cuts from the Federal Reserve off the table for at least the near future. Buyers also face an ongoing headwind from tight inventories; the months’ supply of homes (how long it would take to sell existing inventory at the current very slow sales pace) was 4.4 in April, 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. One piece of good news is that the median price of an existing home is up only 0.9% 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. Considering these cross currents, and the fact that existing home sales have been stuck in low gear since the end of the COVID pandemic, we expect 2026 to likely be more of the same.

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The stock market is on an absolute tear, with the Nasdaq up 5% last week and nearly 13% year-to-date.  The proximate causes include a cease-fire somewhat holding with Iran, a 28% surge in S&P 500 corporate profits in the first quarter, and some consensus-beating economic reports, like Friday’s payroll numbers.

We have been cautious on this market…and overly pessimistic up to this point.  So, should we rethink that? Should we become more optimistic about stocks?

The optimistic case was summed up in an X post by James E. Thorne at Wellington Altus who said there is a “systematic underestimation of an AI-driven productivity revolution…a Cap Ex Super Cycle, [an administration that is] letting the economy run hot, and multiple expansion [due to] a Peace Dividend.  History suggests that when productivity waves coincide with supply-side policy and geopolitical de-escalation, as in the 1990s, both earnings and multiples expand beyond historical norms.”

Let’s go through this list one item at a time.  1) Is AI really driving a productivity boom?  According to McKinsey, 88% of companies say they use AI in at least one business function, but just 7% say they have expanded its use enterprise wide.  As far as we know, there are little data showing a direct correlation between AI and profitability.  While many could surmise this, it remains a forecast.  And, while, capex is growing, it is concentrated in (or related to) data centers.  Excluding that, investment is weak.  A Super Cycle is an exaggeration.

Events in the Middle East are certainly promising.  Having the UAE exit OPEC is a big deal.  It suggests a more “go it your own way” free market world, not one divided into factions.  However, Iran seems a long way from being willing to accept this reality and we are not convinced a “peace dividend” is really in the cards.  We hope and pray that it is, but we haven’t seen a Peace Dividend or full-blown geopolitical de-escalation yet, just hope.

Finally, are we really in a Supply Side revolution?  Well, Reagan cut the top income tax rate from 70% to 28%.  Other than tax cuts for tips, social security, and overtime, the top tax rate is the same today as it was last year, and will be next year.  Overall government spending has been flat, which means it is declining as a share of GDP, but Congress has yet to pass a budget that promises continued spending restraint in the future.

Regulation has been reduced, but could be expanded again if a more pro-regulation president gets elected in 2028.  Virginia is a perfect example…the new governor is trying to reverse the direction of policy put in place under the previous governor.  Recent spending and regulatory restraint don’t pre-commit future presidents and congresses to the same policies.

So, while many positive developments are taking place, the idea that we are entering into a long-term secular bull market seems a stretch.  The PE ratio on trailing earnings of the S&P 500 is currently near 29.  When Reagan entered office and cut both tax rates and spending, and broke the back of inflation, the PE ratio was 8.  Even if policies today were equally as good, the same kind of boom should not be expected.

We aren’t pessimistic even though it might sound that way.  The US (as it has done for 250 years) is pushing back against feudalism in all its forms.  At the same time, AI is a transformative technology.  But it will take time for these things to fully play out, and we think markets are underestimating the time, energy, and volatility it will take.

Brian S. Wesbury – Chief Economist

Robert Stein, CFA – Deputy Chief Economist

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Implications: Solid labor market, but not without some blemishes.  Nonfarm payrolls rose 115,000 in April and 99,000 including downward revisions for prior months – either way beating the consensus expected 65,000.  Meanwhile, the unemployment rate remained at a relatively low 4.3%.  The job gains in April itself were led by health care & social assistance, transportation & warehousing, and retail.  Total hours worked in the private sector rose 0.3%.  We like to follow payrolls excluding government and health care & education (which are often driven by government policies), which rose 77,000 in April.  Notably, federal payrolls were down 9,000 in April.  Compared to January 2025, federal payrolls excluding the Post Office and Census are down 337,000, or 14%.  Leaving out the end of the Census every decade, the decline in federal payrolls in the past fifteen 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.  However, not all the details were as robust as the headlines.  For example, although they rose in April, payrolls excluding government and health care & education are down 107,000 from a year ago.  Civilian employment, an alternative measure of jobs that includes small-business start-ups, dropped 226,000 in April.  That series can be volatile month-to-month but is worth watching.  Yes, the unemployment rate was steady, but that was due to a 92,000 decline in the labor force (people working or looking for work), which ticked the participation rate down to 61.8%, the lowest since 2021.  Average hourly earnings rose a tepid 0.2% in April, which is very likely below the pace of inflation for the month.  Put it all together and we expect continued jobs gains in the months ahead but at a noticeably slower pace than the headline 115,000 for April.  In other recent news, initial jobless claims rose 10,000 last week to a still-low 200,000; continuing claims declined 10,000 to 1.766 million, also low.  Construction increased 0.6% in March after a 0.2% dip in February, with the net gain for those two months led by single-family home building.  Productivity (output per hour) increased at a 0.8% annual rate in Q1 and is up 2.9% from a year ago, a good sign versus the long-term trend of about 1.5%.  Unit labor costs increased at a 2.3% rate in Q1 but are up a mild 1.2% in the past year.  

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In Fiscal Year 2025, a staggering 69% of federal spending was allocated to payments to individuals, near the highest share ever recorded. In this week’s “Three on Thursday” we look at the composition and evolution of federal spending over history, and how the Federal Government has become not much more than the world’s largest money transferring machine. For deeper insights, click the link below.

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