Implications:  Consumers started the second half of 2026 on healthy footing, with income rising 0.4% in July and spending up 0.2%.  Starting with income, growth was led by private sector wages and salaries which rose 0.3% (up 3.8% in the past year) and government transfer payments which were up 0.6% in July (+5.1% from a year ago).  While the 3.8% increase in private sector wages over the past year sounds decent on paper, remember that inflation is up 3.7% over the same period, meaning consumers’ purchasing power is virtually unchanged.  On the spending side, personal consumption rose 0.2% in July, led by financial services and health care, which were partially offset by a decline in spending on gasoline.  Collectively, goods spending (which includes energy costs) fell 0.7% in July, while spending on services increased 0.6%.  The personal saving rate — which tracks how much after-tax income is not consumed — rose to 3.0% in July but remains near the lowest readings since the COVID-era in 2022 (and before that during the Great Financial Crisis in 2008!).  This low level of saving allows for more spending today but isn’t sustainable long-term.  The area of today’s report that will get the most attention from the Fed is the latest reading on inflation. PCE prices – the Fed’s preferred inflation metric – rose 0.2% in July, while the year-ago reading remained at 3.7%.  “Core” prices, which strip out the volatile food and energy categories, also rose 0.2% in July, with the year-ago comparison now at 3.3%, a notable uptick from the 2.9% pace for the twelve-months ending in July 2025.  The Fed will be watching the data closely while trying to determine how monetary policy – which operates with a lag – should respond as inflation remains stubbornly above their 2.0% inflation target.  We wish the Fed would pay more attention to the M2 measure of the money supply, which rose 0.4% in July and is up 5.4% from a year ago.  That is still below the historical growth rate of about 6%, but worth watching closely in the months ahead for signs of any acceleration.  Recent discussion around the Treasury potentially using funds from the Treasury General Account (TGA) to support bond market liquidity for long duration treasuries could lead to a pickup in M2 growth if implemented.  As things currently stand, we expect the Fed will remain on pause for the foreseeable future as they wait for the fog to clear and a better picture of sustained inflation pressures to come into view.  

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Implications:  Hold off on GDP for a moment. The most important data in this morning’s report was on economy-wide corporate profits, which posted the largest increase in five years with a 9.1% jump in the second quarter and are now up 22.8% from a year ago. The Federal Reserve, after posting massive losses for three consecutive years, finally returned to profitability at the end of 2025 and eked out its third consecutive profit in Q2. Excluding the Fed, corporate profits were up 8.4% in Q2 and 20.6% from a year ago – the fastest growth for any four-quarter period since late 2021.  The increase in Q2 was led by a 10.4% jump in profits earned from domestic non-financial industries, boosted by strong earnings in the technology and energy sectors. Profits from domestic financial companies increased 8.0%, while profits from the rest of the world rose 3.5%.  Despite the rapid growth in Q2, plugging these profits into our Capitalized Profits Model suggests stocks remain overvalued.  In addition, the SpaceX IPO and tariff refunds may have boosted profits artificially. Now back to GDP and the rest of this morning’s report.  Real GDP for the second quarter was unrevised at a 1.5% annualized rate, but reflected a slightly better mix, as upward revisions to personal consumption and business investment were offset by small downward revisions to net exports, inventories, and government purchases. For a clearer picture of underlying growth, we focus on “core” GDP – consumer spending, business fixed investment, and residential construction – excluding more volatile components like inventories, government outlays, and trade. Core GDP was revised higher to a 4.2% annual rate from an initial 3.9%, the fastest pace since early 2023, and is now up 2.7% from a year ago.  So why did headline GDP grow much slower than Core GDP?  Primarily because trade continues to move in volatile swings, shaving off 1.1 percentage points from the headline in Q2.  The most worrisome part of the report was that inflation remains far from the Fed’s 2.0% target, with GDP prices rising at an upwardly revised 6.4% rate in Q2 and are now up 4.4% from a year ago. Nominal GDP rose at an 8.0% rate in the second quarter and is up 6.6% versus a year ago, both figures well higher than the current 3.625% target on short-term rates. That said, much of the inflation pick-up in the second quarter can be traced to the surge in energy prices following the war in Iran and temporary closure of the Strait of Hormuz, and we expect the Federal Reserve to remain on pause as they wait for a better picture of sustained inflation pressures to come into view.

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Implications: New homes sales were softer than expected in July, posting the weakest reading since the start of 2026. Sales are now at an annual pace of 607,000, coming in at the lower end of pre-pandemic levels, which has been a ceiling of sorts for activity the past couple of years.  Unfortunately, the ongoing conflict with Iran and its impact on energy prices and inflation have introduced new challenges. First, financing costs have risen, with the average 30-yr fixed mortgage rate up roughly 60 basis points since the start of the conflict.  Second, despite a new Chairman at the Federal Reserve, further rate cuts are on hold for the time being. But while buyers are unlikely to get much help from interest rates, the good news is that prices have been trending lower for new builds in the past several years. Median sales prices are down 14.4% from the peak in October 2022.  Meanwhile, the Census Bureau reports that from Q3 2022 to Q2 2026 (the most recent data available) the median square footage for new single-family homes built rose 2.5%. So, buyers are seeing a drop in the price per square foot, not just smaller/lower cost options.  This is partially the result of developers offering incentives to buyers in order to move inventory. Supply has also put more downward pressure on median prices for new homes than existing homes.  The supply of completed single-family homes has been trending down recently but is still up 280% versus the bottom in 2022. This contrasts with the market for existing homes, which continues to struggle with convincing current homeowners to give up the low fixed-rate mortgages they locked-in during the pandemic to list their homes. While financing costs continue to add uncertainty and keep buyers on the sidelines, less expensive options and an abundance of inventories may give home sales a modest boost in the second half of 2026. In other housing news this morning, the FHFA index remained unchanged in June but is up 2.3% in the past year, while the national Case-Shiller index increased 0.1% in June and is up 1.5% in the past year. On the employment front, initial jobless claims fell last week by 6,000 to 206,000; continuing claims rose 18,000 to 1.799 million.  These figures signal continued job growth.  Finally, on the manufacturing front, the Richmond Fed index, a measure of mid-Atlantic factory activity, slipped to +4 in August from +5 in July.

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James Carville, Bill Clinton’s chief political advisor, once quipped that if he could be reincarnated he wanted to come back as the bond market because “You can intimidate everybody.”

He’s being proven right.  The yield on the 30-year Treasury Bond finished Friday at 5.27% – 55 basis points higher than six months ago, and near the highest level since mid-2007.

This rise in yields has the Treasury Department in a tizzy.  Treasury Secretary Scott Bessent let Japan use a special repo facility to support the Yen without having to sell any US bonds.  Then the Treasury did a version of Operation Twist, buying back long-term debt and funding it by issuing more short-term debt.

The financial press, and other analysts, are gravitating toward a few reasons for the rise in yields.  One theory is that markets are increasingly worried about higher inflation.  And because new Federal Reserve Chairman Kevin Warsh is too loyal to President Trump, he won’t increase interest rates to stop it.

The big problem with this theory is that the market’s expectation of long-term inflation, based on the gap between yields on regular nominal Treasury debt and inflation-indexed debt, hasn’t moved higher.  The five-year forward inflation rate starting five years from now is about 2.34%, almost exactly where it was six months ago.  Moreover, why would markets freak out about inflation now?  Jerome Powell, Warsh’s predecessor, presided over an inflation rate that reached 9.0%, the highest since the early 1980s and the bond market didn’t go haywire then. 

Another theory is that markets are getting more optimistic about an improvement in long-term economic growth, given productivity gains tied to AI.  The AI/data center build out also requires lots of capital investment, meaning more types of debt fighting for the same dollars, which could be raising yields for other borrowers, in this case the US Treasury Department.  It will take time to see if this is a correct interpretation, but if it is, then we shouldn’t be worried unless the AI/data center build-out doesn’t help boost economic growth.

Another theory is that the fiscal chickens are finally coming home to roost.  After years of massive deficits, the bond market vigilantes are finally on their horses chasing down the bad guys. 

There are plenty of reasons to be worried about the long-term budget situation.  The national debt is now $40 trillion.  Meanwhile, net interest on the debt is now back above 3% of GDP, like it often was in the 1980s-1990s (after multiple decades at much lower levels).  We are also creeping ever closer to a full depletion of the Social Security Trust Fund.

It is long overdue for lawmakers in both parties to get our fiscal house in order through systematic reductions in the future path of spending, and the sooner the better.  However, some are using the recent move in yields as a misleading indictment of the Trump Administration’s budget measures, in particular making the 2017 tax cuts permanent.  

Yes, this year’s budget deficit (for the fiscal year that ends September 30) is likely to be about 6.4% of GDP, even larger than the last two deficits under President Biden.  But the current fiscal year includes unique one-time tariff refunds of about $166 billion.  Without those, the deficit would be about 5.9% of GDP.

When you focus on spending, the Trump Administration has been relatively frugal.  Total spending in the past twelve months is up only 3.8% compared to the last twelve months of the Biden Administration, in spite of temporary calendar effects that artificially boost that growth rate by about 2 percentage points.  In addition, inflation has averaged about 3%, interest costs have risen, military spending is up, Social Security and Medicare spending are rising on the backs of the baby boomers, and health care costs are driving Medicaid spending higher.

We are certainly not saying that the US fiscal position is good; it’s not.  When the US is paying 3.8% of GDP on net interest payments and the saving rate is just 2.8%, we have a problem that will only get worse.  It’s not sustainable at this point; the deficit would have to be brought down substantially just to call it minimally acceptable.

But a 55 bp increase in long-term yields is not highly unusual and it doesn’t signal that the current Administration is uniquely irresponsible.  Big changes need to come from Washington, DC, but we hope that means even more of a focus on reducing spending, not a lurch toward broader tax hikes.

Brian S. Wesbury – Chief Economist

Robert Stein, CFA – Deputy Chief Economist

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One of the most urgent challenges facing the U.S. economy is not whether we can produce enough energy, but whether our infrastructure can transmit that power to those who want and need it. Over the next decade plus, demand will rise sharply as the nation electrifies its transportation fleet, builds out AI-driven data centers, and reshapes its industrial base through reshoring. In this week’s “Three on Thursday,” we look at the supply-and-demand dynamics that will define the next phase of America’s energy story which looks like it’s just getting started. For more insight, click the link below.

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Implications: Industrial production continued to grow in July, posting a modest 0.2% gain, with the underlying details showing broad-based strength.  All three major categories contributed to the rise, led by a 0.2% increase in manufacturing despite a 2.1% drop in the volatile auto sector, while activity in previous months was revised higher.  Manufacturing excluding autos (which we think of as a “core” version of industrial production) rose 0.3% in July with the typical bright spots present in the core measure.  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, jumped 1.9% in July. High-tech manufacturing is up 11.8% in the past year (the fastest annual rate of any major series) and has risen at a blistering 29.0% annualized rate in the past three months. Meanwhile, manufacturing of business equipment rose 0.8% in July and is up 6.6% in the past year, outpacing the 1.1% gain in overall industrial production and signaling a broader reindustrialization.  Gains extended to the other two major categories, with mining and utilities rising 0.2% and 0.5%, respectively.  The increase in mining output was driven by a substantial jump in drilling activity as well as more extraction for other minerals, which more than offset a decline in oil and gas extraction.  Meanwhile, utilities output (which is volatile and largely dependent on weather from month to month) has been on an upward trend since 2023, following nearly twenty years of stagnation, as power hungry data centers have boosted demand for US power generation.  Finally, in other recent news, the Empire State Index – a measure of factory sentiment in the New York region – rose to +20.6 in August from +15.6 in July.  On the trade front, import prices declined 0.4% in July and export prices fell 1.3%.  In the past year, import prices are up 5.9%, while export prices have risen 8.2%.

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Implications: As expected, the surge in homebuilding in June proved to be short-lived, with housing starts in July lagging even the most pessimistic forecast from any Economics team polled by Bloomberg, falling to a 1.239 million annual rate.  Even worse, the 12.4% monthly decline was due to both the single-family and volatile multi-unit categories, where starts dropped 9.9% and 16.8%, respectively. Looking at the big picture, home construction has been on a downward trend since peaking a month after the Federal Reserve began hiking rates back in March 2022 and now sit 13.5% lower than a year ago, reminiscent of 2019 levels.  Homebuilders have clearly faced a challenging environment in recent years with affordability remaining the key issue. That has taken a turn for the worse in the aftermath of the conflict with Iran, where surging energy costs have had an upward impact on short-term inflation, resulting in a rapid increase in 30-year mortgage rates. These rates have moved roughly 70 basis points higher since February and now sit around 6.8%, double the levels that prevailed through much of 2021. Meanwhile, high home prices, restrictive local building regulations, tighter immigration enforcement making it tough to find or replace workers, and tariffs are also contributing to a rocky environment.  To combat these headwinds, homebuilders had been focused on completing projects, but it looks like that activity has dried up with home completions falling 9.1% in July to a 1.212 annual pace, the lowest level in six years.  The report did offer one positive: permits for new builds rose a stronger than expected 5.0% in July to a 1.443 million annual rate, putting them 3.1% above where they stood a year ago.  Given these developments, it is no surprise to see the NAHB index (a measure of homebuilding sentiment) moving to 35 in August from 34 in July, where a reading below 50 signals that a greater number of builders view conditions as poor versus good (now the 28th consecutive month that has been the case.)  Until affordability meaningfully improves, we expect home construction to remain under pressure.

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The biggest political news of recent months is the rise of the Democratic Socialists of America.  We suppose this started in New York City, with the election of Mayor Zohran Mamdani, but it has spread to Michigan and other states.

This is not the first time the US has tilted toward socialism, it happened in the 1930s when Franklin Roosevelt was President and his Brain Trust was enamored with Stalin and the Soviet Union.

What’s interesting about this movement now is that it is being driven by the younger generation, where a majority of those under 30 years of age have favorable views of socialism.  Part of this is philosophical (the young are often more liberal), but there are real economic issues as well.

Affordability (of housing, food, healthcare) has become a true political problem.  Bernie Sanders and Elizabeth Warren both use “trillionaire” Elon Musk as a punching bag and complain about inequality.

Most people understand socialism isn’t the answer and there is a real question about the staying power of this movement.  Nonetheless, policies are changing.  New York City will open government-run grocery stores.  Many blue states are raising tax rates on high-income earners.  Redistribution is on the rise.

We won’t argue that inequality has been on the rise.  Nor will we argue that affordability is a real issue.  What we will argue about is why this has happened.

Almost every university class in economics teaches about “market failure.”  The idea being that markets don’t take into account externalities, like the environment, or that markets allow greedy people to take advantage of others.  What they rarely teach is “government failure.”  The idea that big government causes slower economic growth and creates more problems than it solves.

For example, we think the affordability crisis is actually caused by big government.  The federal government spends 23% of GDP, state and local governments spend 17% of GDP, and the cost of complying with government regulations eats up 7% of GDP.  Add that all up and 47% of private sector production is either taxed or borrowed and used to pursue government programs.

When nearly half of production is steered to government causes, what the government subsidizes gets more expensive (like college education and health care) while there is less income available to pay for everything else.  It’s not just that houses cost too much, it’s that incomes are reduced by the size of government spending.

So, what about inequality?  It’s true that capitalism gives large rewards to the most productive.  It’s a feature, not a bug.  But inequality today has been driven by the Federal Reserve’s overly easy monetary policy.

Since 2008, the money supply has more than tripled.  Just during COVID it increased by 42%.  The US ended up with 9% inflation, a 40-year high.  But what this really did was drive up the value of assets, houses, land, businesses,…everything.

If you are a Baby Boomer and had accumulated assets over your working life, you won.  If you are Gen Z, and you haven’t had time to accumulate assets, you lost.  You are paying more for everything but you did not experience asset appreciation and your income barely kept up with prices.  No wonder things are unaffordable.

Many in Gen Z are convinced the system is rigged in favor of the Baby Boomers.  But it’s not capitalism that’s rigged; it’s government failure.  We grew government too much and we printed excess money.

The irony is that the failures of government are leading many to vote for even more government.

Throughout the history of the United States we have experimented with policies like this many times.  Usually we course correct.  The big question today is will that happen again?  We hope so.  We hope that people realize “government failure” is the problem.  Not “market failure.”  But for the moment that is not the direction we are headed.

Brian S. Wesbury – Chief Economist

Robert Stein, CFA – Deputy Chief Economist

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Implications:  Retail sales stumbled to start the second half of 2026, falling 0.6% in July, the largest monthly decline in more than a year.  While July’s headline reading was surprisingly weak (coming in below even the most pessimistic forecast submitted to Bloomberg), it’s important to remember that this follows a very strong start to the year and a season of unusually strong tax refunds that have helped to temporarily boost consumers’ spending power.  It’s also worth noting that eight of the thirteen major sales categories rose in July, but declines in the two largest categories – autos and nonstore retailers – more than offset rising spending in categories like clothing, health & personal care, and general merchandise stores.  Nonstore retailers fell 2.2% in July, likely impacted by Amazon moving their Prime Day sales event to June this year after occurring in July last year.  In other words, don’t put too much emphasis on what is likely a temporary slowdown due to a one-off event.  Auto sales also helped lead the decline, down 1.8% in July following a 2.4% jump in June and a 1.0% rise in May.  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 declined 0.3% in July, and if unchanged in August and September will rise at a modest 1.0% annualized rate in the third quarter versus the second quarter average.  One bright spot in today’s report came from sales at restaurants & bars (the only glimpse we get at services in this report), which moved 0.5% higher in July and has now shown healthy growth over the past four months. Nominal retail sales have risen 5.0% in the past year, but factoring in inflation, “real” inflation-adjusted sales are up 1.7% in the past twelve months. We will continue to watch spending and inflation closely in the months ahead as temporary factors fade and we hopefully get a cleaner look at the true health of the US consumer.

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The arrival of new Federal Reserve Chairman Kevin Warsh has renewed the debate over whether the Federal Reserve (the “Fed”) can shrink its balance sheet, reduce the supply of reserves, and still maintain effective control over short-term interest rates.  This week’s “Three on Thursday” examines the evolution of the Fed’s role in the banking sector, its current state, and the challenges that could stand in the way for Warsh. For more insight, click the link below.

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