Earlier today, our Chief Economist Brian Wesbury testified before the U.S. Senate Committee on Homeland Security and Governmental Affairs on the Federal Reserve's (the "Fed") “abundant reserve” policy. So for this week’s “Three on Thursday” we thought it appropriate to look at the newly released quarterly financial report on the combined balance sheet of the 12 Federal Reserve Banks through the third quarter. For a deeper dive, click the link below.

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Implications: The U.S. trade deficit narrowed unexpectedly to $52.8 billion in September, the smallest since mid-2020. The decline in the deficit was due to a large increase in exports, which rose $8.4 billion. Imports edged up a more modest $1.9 billion. The President may see this as a win. After all, the core aim of Trump’s trade agenda has been straightforward: fewer imports and more domestic production. But whether that’s what we’re actually seeing is far less certain. We like to focus on the total volume of trade, imports plus exports, as it shows the extent of business and consumer interaction across the US border. This measure grew by $10.3 billion in September but is up only 0.4% in the past year, and down 10.3% from the peak hit just earlier this year in March 2025.  The decline in trade volumes versus earlier this year could signal a real shift in global supply chains — reshoring, decoupling, and rising U.S. output, exactly what the President wants to see. Or it could be pointing to something less encouraging: softer demand both at home and abroad.  At this point, the data don’t offer a clean answer.  Employment growth has slowed, particularly in goods-producing industries. For a drop in imports to translate into a lasting economic win, it needs to be accompanied by a clear rebound in U.S. manufacturing and investment—and so far, that resurgence remains tentative. Meanwhile, the GDP math has flipped. Imports subtract from GDP, and their surge in Q1 weighed heavily on overall growth. Net exports alone shaved roughly five percentage points off the growth rate, leaving real GDP contracting at a 0.7% annualized pace in Q1. But as those front-loaded imports peaked in March and receded in Q2, trade became a tailwind, helping lift growth in the second quarter.  It now looks like net exports will not have nearly as large an impact on GDP as it did in the first half of the year but should add to growth in the third quarter.  At the same time, the landscape of global trade continues to evolve. China, once the dominant exporter to the U.S., has slipped to a distant third behind Mexico and Canada with exports to the US down 24.7% YTD through September versus the same period last year. And in today’s report, the dollar value of U.S. petroleum exports once again exceeded imports, marking the 43rd consecutive month of America being a net exporter of petroleum products. Petroleum exports were about 37% higher than petroleum imports in September, a new record high surpassing the previous peak set in April 2020. In other news today, initial jobless claims rose 44,000 last week to 236,000 after plummeting during the shortened Thanksgiving week to 192,000; continuing claims for that Thanksgiving week fell 99,000 to 1.838 million.  Look for a rebound in continuing claims in the next report, just like the rebound in initial claims in today’s report.

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The Federal Reserve cut rates by another quarter percentage point today, the last meeting of 2025, and maintained its outlook for only one cut in 2026.     

Beyond today’s rate cut, the Fed statement was little changed from the meeting in October.  There was one new section added, in which the Fed – which ended the quantitative tightening process at the last meeting – announced that they will begin making short-term Treasury purchases as needed to maintain ample reserves in the banking system. In the section related to the employment market, text was removed that had previously stated the unemployment rate “remained low” and now simply notes that the unemployment rate has “edged up” from earlier this year.  Notably there were three dissents to today’s actions, as Fed Governor Stephen Miran voted for a larger 0.5% cut, while Kansas City Fed President Jeffrey Schmidt and Chicago Fed President Austan Goolsbee voted to hold rates steady.

With little forward guidance on Fed thinking in the published statement, focus shifted to today’s release of updated economic projections for hints on what the Fed believes is set to come.  For 2026, the largest change came in the real GDP forecast, which rose to 2.3% from 1.8% at the September meeting. Meanwhile, the forecast for PCE inflation declined to 2.4% in 2026, from the 2.6% forecast in September, and there was no change to the unemployment rate forecast of 4.4%.  Forecasts beyond 2026 were little changed.

Early in the press conference, Chair Powell was asked what led to the more optimistic forecast on the growth front, which would be a notable pickup after a slowing of growth in 2025.  Put simply, consumers continue to spend and the rise in business investment in AI and associated data centers has run ahead of expectations, and looks likely to continue to be strong in the year ahead.  This hasn’t substantively shifted the employment outlook, as history shows innovations haven’t historically resulted in broad job loss, but rather have created new – and often higher-paying – jobs in areas related to the new technology. While some companies have reported job cuts, broader data on unemployment claims are yet to show much reaction from AI deployment to-date.

The question that caught our attention was related to the Fed’s announcement around potential Treasury purchases to support banking reserve levels.  We believe that quantitative easing and the massive increase in the size of the Fed’s balance sheet – moving us from a scarce reserve system to an abundant reserve system, in which the Fed now pays banks hundreds of billions of dollars per year to simply hold the reserves – was a massive mistake, and think the banking system and monetary policy in general would benefit from a return to the system in place before extraordinary measures were taken. The Fed has taken an opposing view, believing that its balance sheet should remain exceptionally large, and argued today that it should probably expand by around 25 billion dollars per month to keep pace with growth in the broader economy.  There is a hearing scheduled by the Senate Committee on Homeland Security and Governmental Affairs for tomorrow – at which Brian Wesbury will be testifying – to discuss this very issue, and we hope it shines light on a problem that too few are paying attention to.  

Between now and the Fed’s next meeting in late January, there will be a plethora of data on both inflation and employment to clear some of the fog that remains from the government shutdown and associated lack of data releases.  Given today’s comments, we expect the Fed to hold at that meeting, but we also believe that a March cut could be on the table if employment data weakens further.  Chair Powell’s term ends in May, and regardless of whether he is replaced by National Economic Council head Kevin Hassett or former Fed Governor Kevin Warsh (either would give President Trump a 4-3 majority of appointees), there could be a substantive shift in the tone coming from the Fed with the changing of the guard.  From rates to reserves to potential changes to the regional Fed bank system itself, 2026 could be a boisterous year for Fed watchers. We, meanwhile, will be keeping our eyes on what it all means for the M2 money supply, which remains our North Star on inflation.

Brian S. Wesbury – Chief Economist

Robert Stein, CFA – Deputy Chief Economist

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There are two very important meetings about monetary policy this week but, so far, most of the public only knows about one of them.  

On Wednesday the Federal Reserve will decide what to do about short-term interest rates and both the futures market and our economics team thinks the Fed will almost certainly reduce rates by another quarter percentage point, just like it’s done at the last two meetings in September and October.

That meeting will also bring forth a new set of economic projections for the next couple of years – don’t expect fireworks – and will end with a press conference with Fed Chairman Jerome Powell, where he will provide hints about additional Fed moves, if any, in the early part of next year.  We think Powell will signal that investors should assume rate cuts will come more staggered; like every other meeting, rather than at every meeting in early 2026.

But the other monetary policy event, the one that fewer are paying attention to, might be much more important in the long run.  That’s a hearing to be held on Thursday, by the Chairman of the Senate Committee on Homeland Security and Governmental Affairs, Rand Paul, titled “The Fed’s Big Bank Welfare Program: Oversight of the Fed’s IORB Regime.”  (Full Disclosure: Brian Wesbury will be testifying at this hearing while the Fed is sending former Vice Chair of the Fed, Donald Kohn.)

One reason this hearing is important is because it dovetails with President Trump looking for a successor to Jerome Powell.  As of this weekend it looks like Kevin Hassett, the head of Trump’s National Economic Council, has the insider track, but we wouldn’t count out former Fed Governor Kevin Warsh.

Either way, the new leader at the Fed, who would likely replace Powell by May, would have the power to shift the Fed in a very different direction.  Monetary policy would still be made by the Federal Open Market Committee (FOMC), which includes the full slate of Fed Governors headquartered in Washington, as well as a rotating portion of the regional Fed bank presidents.  But the new Fed chief would have a 4-3 Trump appointed majority on the Board.  

That 4-3 majority is important because if the Board wants, it could vote to remove regional bank presidents.  In theory, these removals are only supposed to be “for cause” but some regional bank presidents might not fight the pressure.  It is true that bank presidents could go to court, like embattled Fed Governor Lisa Cook, but the courts might be less likely to fight a Fed majority asking for removal versus Trump asking for himself, like he did with Governor Cook.  We don’t think courts have jurisdiction over the internal workings of the Fed and it’s hard to imagine them telling the Fed which votes it must accept on policy decisions.   

In the meantime, Treasury Secretary Bessent has suggested changes to the antiquated system of regional Fed banks, a system which dates back more than a century.  He suggested requiring any potential President of a regional Fed Bank to have been a resident of that district for at least three years.  We would go even further and suggest reducing or even eliminating the regional banks and the duplication of all sorts of functions, to streamline the system and reduce spending at the central bank.

Another huge issue is that the Fed has been losing money hand over fist the last couple of years because it’s paying banks interest on the massive amounts of reserves it’s pumped into the financial system, while earning less yield on the debt securities the Fed itself owns.

Senators Ted Cruz, Rick Scott, and Rand Paul have bills to end these payments.  We think these bills are a great start but the process needs to be handled with delicacy as the payments are the counterpart to the abundant monetary policy regime the Fed embarked on almost twenty years ago with multiple rounds of Quantitative Easing.  Both these policies should be wound down at the same time and the Fed prevented from embarking on similar policies in the future. 

Yet another issue investors need to pay attention to is that the Fed is in the process of reducing the liquidity requirements it imposes on banks while it is still cutting short-term rates and ending quantitative tightening.  In turn, this set of policies could result in a pick-up in the growth rate of M2.  The surge in M2 in 2020-21 was the harbinger of the inflation surge in 2021-22.  Then the drop in M2 from mid-2022 through 2023 signaled the current slowdown in inflation.

The M2 money supply is up 4.7% from a year ago.  That is consistent with some continued moderation in inflation.  But if recent policy measures, like loosening the liquidity ratio, lead to a pick-up in M2 growth, then the Fed will be further delayed in getting inflation down to its 2.0% target.

Either way, this is a key week for monetary policy, both in the short-term and, potentially, the long run.

Brian S. Wesbury – Chief Economist

Robert Stein, CFA – Deputy Chief Economist

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Implications:  Consumers closed out the third quarter with healthy growth in both income and spending, up 0.4% and 0.3%, respectively, in September.  Starting with income, private-sector wages and salaries rose 0.4% in September while government transfer payments increased 0.2%.  This is a welcome shift from the trend that started in early 2024 where government transfer payments have become an increasing share of consumers monthly spending power.  We hope to see private earnings continue to rise at a faster pace than government transfers – which are not a reliable (or desirable) long-term source of income – and will be watching this data closely in the year ahead.  On the spending front, personal consumption rose 0.3% in September.  Services led the way, up 0.4%, with outlays on housing, health care, and financial services rising the most.  Meanwhile spending on goods was flat as a gain in outlays for gasoline was offset by slowdowns for autos, recreational goods, and clothing.  It must, however, be noted that the growth in spending was almost entirely due to higher prices, with inflation-adjusted spending flat on the month.   PCE prices, the Feds preferred inflation metric, rose 0.3% in September while the year-ago reading rose to 2.8%.  That 2.8% pace in the past twelve months is up from the 2.3% rate for the twelve-months ending September of 2024, but it’s important to note that inflation readings between May and November of last year were relatively subdued before rising at an above average rate to start 2025.  This will be worth keeping an eye on in the months to come as continued monthly readings in the 0.2%-0.3% range would result in the year-over-year reading start to come back down towards the 2.0% target.  Pair this with signs from the housing market that rent prices have subdued (housing is the single largest component of PCE prices), while M2 growth continues to run below the historical 6% rate, and we believe inflation is unlikely to accelerate in the year ahead.  And with a tepid jobs market pushing the employment side of the dual mandate towards center stage in Fed voters’ minds, it looks likely rate cuts will continue at the Fed meeting next week, with some further cuts to come in 2026.  In other recent news, initial jobless claims declined 27,000 last week to 191,000 (this was the week of Thanksgiving, and we wouldn’t read too much into this notably low reading); continuing claims fell 4,000 to 1.939 million.  On the autos front, cars and light trucks were sold at a 15.6 million annual rate in November, up 2.0% from October, but down 5.6% from a year ago.

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As families gathered around the table last week, Americans weren’t just carving turkeys; they continued to set records. In this week’s “Three on Thursday,” we take a closer look at what Thanksgiving week revealed about the economic backdrop. For a deeper dive, click the link below.

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Implications:  The resiliency of the sector responsible for the lion’s share of US output was on display once again in November, as the ISM Services index beat consensus expectations and rose to a nine-month high of 52.6.  Despite continued weakness in its counterpart survey on manufacturing, the service sector has expanded in ten out of the last twelve months.  The modest uptick in the headline index was largely driven by the supplier deliveries component, which surged to a thirteen-month high of 54.1 (a reading above 50 signals longer wait times), likely the result of air traffic disruptions stemming from the government shutdown according to the report.  Partially offsetting this gain was a pullback in the new orders index which remains in expansion territory at 52.6.  Survey comments indicate a fractured growth picture, as some voice concerns about the impacts of additional tariffs and another potential government shutdown in January, while others indicate business as usual.  Notably, a survey comment from the Retail Trade industry wrote, “Business continues to be strong, driven by customer traffic. Pricing stable.”  Still, this bumpy path has kept service companies defensive in their hiring efforts.  The employment index continued to signal contraction in the service sector in November (but at slower pace compared to last month), with the category rising from 48.2 to 48.9.  That makes eight out of the last nine months where the employment index has been below 50.  Service companies – once hamstrung with difficulty finding labor – have begun reducing their headcounts, with more industries (eight) reporting lower employment in November than higher (six).  Finally, the highest reading of any category was once again the prices index, which fell to a seven-month low of 65.4.  Though the index remains elevated, it is still far from the worst we saw during the COVID supply-chain disruptions, when the index reached the low 80s.  While inflation pressures remain, the M2 measure of the money supply has grown very slowly over the past three years.  Last week's data showed M2 rose 0.4% in October and 4.7% over twelve months – below the historical growth rate of ~6% – suggesting lower inflation and growth in the year ahead.  In other news this morning, ADP reported private payrolls declined 32,000 in November, which should translate into a tepid official Labor Department report for job growth last month.

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Implications:  We finally got a look at industrial production for September now that the shutdown at federal government data agencies has ended, and the details were ugly. While industrial production eked out a small gain of 0.1% and manufacturing was unchanged in September, when including big downward revisions to prior months the September numbers were -2.4% and -3.2% respectively.  To put that in context, all growth in both series since the aftermath of the COVID pandemic in 2022 was essentially revised away.  Turning our focus to September itself showed a more mixed picture. The volatile auto sector posted a decline of 2.3% in September.  However, manufacturing ex-autos (which we think of as a “core” version of industrial production) posted a gain of 0.1%, leaving overall manufacturing unchanged.  Meanwhile the typical bright spots in the “core” measure were present 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, posted a gain of 0.6%.  High-tech manufacturing is up 10.8% in the past year, the fastest pace of any major category.  The manufacturing of business equipment also rose 0.7% in September.  This category is up a strong 9.1% in the past year, signaling reindustrialization in the US outside of just the high-tech industries mentioned above.  Looking outside of manufacturing, utilities output (which is volatile and largely dependent on weather) was also a source of strength, with activity rising 1.1%.  Finally, the mining sector was unchanged in September. A faster pace of oil and gas production as well as the drilling of new wells was offset by less extraction of other metals and minerals. Look for the recent upward trend in activity in this sector to continue as the Trump Administration takes a more aggressive stance with permitting.  Lastly, on the trade front, import and export prices were both unchanged in September.  In the past year, import prices are up 0.3% while export prices have risen 3.8%.

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Implications:  Manufacturing activity weakened again in November, as the ISM Manufacturing index missed consensus expectations and declined to a four-month low of 48.2.  This makes nine consecutive months the index has been below 50, continuing a pattern that stretched all of 2023 and 2024.  Though many believed the downturn was over when the index briefly rose above 50 in January and February, the subsequent streak of contractionary readings indicates the sector continues to face headwinds.  Looking at the details, just four of the eighteen major manufacturing categories reported growth in October, while nearly triple (eleven) reported contraction.  The overall decline was driven by weakening demand, softer employment conditions, and faster supplier deliveries.  The new orders index – which returned to expansion territory briefly back in August – continues to struggle for traction, as the index fell to a four-month low of 47.4.  Order books were already weak heading into this year, and now survey comments blame trade uncertainty for the weakness as many customer orders have been placed on pause until stability returns.  This has caused companies to look for ways to reduce overhead, most notably through their hiring efforts.  The employment index fell deeper into contraction at 44.0, with only two major manufacturing categories (Computer & Electronic Products and Machinery) reporting an increase in employment in November versus twelve reporting a decline.  One component that weighed on the headline index – but is not necessarily negative – was a sharp drop in the supplier deliveries index, from 54.2 to 49.3. Faster deliveries typically signal fewer supply chain bottlenecks, even though they mechanically reduce the headline reading.  Meanwhile, it appears that inflation pressures have begun to stabilize, with the price index ticking up to 58.5 from 58.0 after declining for four consecutive months.  The 58.5 reading is below the recent peak of 69.8 in April, and well below the levels during the post-COVID inflation surge.  Given the slow growth in the M2 measure of the money supply over the last 3+ years, we expect inflation to trend lower in the coming year. 

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In the ten years prior to the onset of COVID, the consumer prices index rose at an average annual rate of 1.7%. Since the onset of COVID the overall CPI has risen at a 4.2% annual rate. Inflation peaked at about 9.0% back in 2022 but is still hovering between 2.5 and 3.0%, which is above the Federal Reserve’s official target of 2.0%.

There are reasons to believe inflation may decline in the year ahead. These include slower growth in the M2 measure of the money supply. While most ignore it, M2 surged 2020-21 signaling the high inflation to come. Since April 2022, it has only grown 2%, signaling the moderation of inflation that the US has seen.

Inflation pushed home prices higher, but the rate of increase has slowed sharply. This could possibly be related to the strict enforcement of immigration laws. Some focus on the fact that fewer workers in construction trades could push up labor costs but forget that it also reduces demand for the existing stock of rental units.

However, there are also some reasons to be concerned about inflation over the medium-term and beyond. It appears that the political consensus in favor of keeping inflation low has eroded. Some economists believe targeting a higher inflation rate (either explicitly or quietly) would give more room for potential growth to expand, while others look back on the pre-COVID trend as risky. With low inflation, interest rates are also lower, meaning the Fed has less room to cut rates in an economic emergency.

If inflation and rates were generally higher, they would have more room to cut rates in another crisis. Perhaps this is why the Fed is considering relaxing capital rules on banks that could free them to lend more aggressively, which would boost the money supply. We have long said that “abundant reserves” are like storing gasoline near your water heater. Cutting capital and liquidity ratios would release some of those reserves.

And this brings us to the most dangerous reason to support inflation. Some think with the national debt at $38 trillion, higher inflation would reduce the real value of that debt and make it easier to pay off with inflated dollars.

But we think policymakers would be making a big mistake if they don’t wrestle inflation back down and keep it there. Higher interest rates increase the cost of capital, while inflation erodes growth. The Reagan boom happened, in part, because Paul Volcker ran a tight monetary ship which brought inflation down after the high-inflation, and slow growth, 1970s.

Moreover, even though the national debt is officially $38 trillion, the unfunded liabilities in Social Security and Medicare – the present value of benefit promises to future retirees over and above the expected revenue in these programs – are roughly $76 trillion. And this form of debt is inflation indexed, in the sense that Social Security benefits are directly indexed to inflation and Medicare spending rises if overall inflation is higher.

So even if higher inflation can temporarily surprise Treasury bondholders, diluting their bonds’ value, as shorter-term debt is rolled over, the US will have to pay higher rates on new debt, while not fixing the long-term entitlement problem.

Here's a better idea and one that has proven successful in the past: have the Fed focused on price stability while Congress and the President take measures (together or separately) to get our fiscal house in order. On the latter front, there are some tentative green shoots. In the past twelve months the federal deficit has been $1.8 trillion versus $2.0 trillion in the twelve months ending in October 2024.

That’s why the next few months of budget battles are important. Will we continue to make (gradual) progress against the deficit? Let’s hope so. In the meantime, President Trump is contemplating who he will pick as the next Fed chief. If the next leader is willing to risk higher long-term inflation to try to use monetary policy to fix our long-term fiscal issues, that would be a negative sign.

The US is at a serious inflection point. While many seem to think inflation can help fix it, we don’t see how.

Brian S. Wesbury – Chief Economist

Robert Stein, CFA – Deputy Chief Economist

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