The United States consumes a large share of its GDP; China, not so much.  The result is Yin and Yang.  On net, China produces and the US consumes.

Treasury Secretary Scott Bessent put it this way last week at a Senate hearing – “China has a singular opportunity to stabilize its economy by shifting away from excess production towards greater consumption.”

That is the rallying cry for tariffs and trade negotiations.  And while the US government seems to blame it all on China, it is also true that the US has a “singular opportunity” to shift away from excess consumption toward greater production.

John Maynard Keynes convinced a troubled world that markets periodically fail and when it happens more government spending is the answer.  On the blackboard, Keynesian economics is pretty simple: Tax those with a high “marginal propensity to save” and give to those with a high “marginal propensity to consume.”  And since consumption is almost 70% of GDP, this transfer of wealth will lift growth.

In the real world, it doesn’t actually lift GDP, but it does lift consumption.  Since 2008, real consumer goods expenditures are up 62% in the United States.  Unfortunately, the most aggressive measure of US “value-added” manufacturing is only up 14%.  In other words, because of government policy, the US economy is off kilter.  We consume more than we produce…the exact opposite of China.

We don’t know whether China is intentionally taking advantage of the US, or whether US policies are just making it too easy, but blaming the full problem on China is not right.

The more the US redistributes and regulates industry, the more the US consumes and the less it produces.  The real fix is to cut government spending, cut tax rates, and reduce regulations.  But the President can’t do all these things without Congress.  The President can increase tariffs, which are taxes, but the Courts will eventually decide whether the methods he used to raise tariffs are legally acceptable.

In other words, we can blame China for consuming less and producing more, or we can look at the US and realize we consume more and produce less.

In a way, this issue resembles the debate around MAHA – the movement to Make America Healthy Again – and the simple point it’s trying to make.  The US has more obesity and diabetes than it should.  And the reason, according to MAHA, is that our food supply is lousy.  Right now, says MAHA, what we do is treat the symptoms created by our food complex, not the root cause.

Now think about tariffs.  We import more because we over-consume and under-produce.  Tariffs treat a symptom of bad government policies, but do not address the real problem.  And it’s not all China’s fault.

Don’t get us wrong: We are not asserting that China is playing fair; they aren’t.  They steal intellectual property, they pay workers less than they should, and they take advantage of the US’s consumer-driven society.  On top of that, they want to undermine US geo-political strength.

What we are saying, is that the US needs to stop subsidizing consumption and punishing production.  The US, for almost 100 years, has listened to Keynes and followed a Keynesian path.  Higher taxes, more spending, and too much regulation.  If we really want to fix this, we can’t just ask China to consume more and produce less.  The US must do the opposite.

In this world of “dueling economies” the US continues to shoot itself in the foot while trying to blame other countries.  It’s time to get our own house in order, regardless of what China does.

Brian S. Wesbury – Chief Economist

Robert Stein, CFA – Deputy Chief Economist

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Real (inflation-adjusted) GDP shrank in the first quarter of 2025—marking the first contraction since 2022—and instantly igniting partisan crossfire. In this week’s Three on Thursday, we cut through the political noise and dissect the real drivers behind the Q1 slump and assess whether the weakness is likely to persist or reverse in Q2. 

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Implications:  While chatter about the threat of higher inflation from tariffs has echoed across the media, producer prices haven’t got the memo.  Following declines in March and April, producer prices rose a modest 0.1% in May.  Even the typically volatile food and energy categories had a quiet month in May, with food prices rising 0.1% and energy prices unchanged.  “Core” producer prices – which exclude food and energy – also rose 0.1% in May and are up 3.0% versus a year ago, with both goods and services showing prices slightly higher last month.  In a twist of irony, prices for goods, which would logically seem the area most exposed to higher import costs, rose 0.2% in May but are down at a 2.8% annualized rate over the last three months.  In May, rising costs for tobacco, poultry, and gasoline were partially offset by declining costs for jet fuel, pork, and carbon steel scrap.  Services, which represent a much larger share of the economy, saw prices rise 0.1% in May as final demand trade services (think margins received by wholesalers) increased 0.4%, while final demand transportation and warehousing services declined 0.2%.  The Federal Reserve meets next week to discuss the path forward for rates, and while we don’t anticipate a rate cut to be announced next Wednesday, they certainly have a lot to debate as their much-discussed concerns over a return of inflation pressures has proven once again that the Fed’s inflation models need some tweaking.  In other news this morning, initial jobless claims were unchanged last week at 248,000, while continuing claims rose 54,000 to 1.956 million.  These figures are consistent with continued job growth in June, but at a slower pace than last year.

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Implications:   While the Federal Reserve and many other analysts remain focused on tariffs, inflation came in below expectations for the fourth month in a row in May, rising only 0.1%.  Like we’ve been saying for some time, the link between tariffs and inflation is overrated. Yes, tariffs can raise prices for the tariffed items, but they leave less money left over for other goods and services. They shuffle the deckchairs on the inflation ship, not how high or low the ship sits in the water.  That’s up to the money supply, which has been essentially flat since April 2022.  We believe this relative monetary tightness is why inflation has slowed recently, up at a 1.0% annualized rate in the last three months.  Diving into the details, food prices rose 0.3% in May while energy prices declined 1.0%, driven by a 2.6% drop in gasoline prices.  “Core” prices, which strip out food and energy, rose 0.1% in May versus a consensus expected +0.3%.  Although core inflation has been much harder to subdue than overall inflation and is still up 2.8% in the last twelve-months, it has finally started following suit, up 1.7% annualized in the last three months.  Notably, prices continue to fall in categories many expected to be impacted by tariffs, including apparel (-0.4) and new vehicles (-0.3%).  We also like to follow “Supercore” inflation – a subset category of prices that excludes food, energy, other goods, and housing rents.  Fed Chair Jerome Powell said back in 2022 that they follow this category closely, though he stopped mentioning it when this measure stopped showing progress versus inflation. However, it appears the tide has finally turned for the category, with supercore prices up at just a 0.1% annualized pace in the last three months, while the year-ago comparison has fallen from 4.1% in January to 2.8% in May. That’s so much progress Powell might mention it next week at his press conference! Notable decliners this month within the supercore category were prices for airline fare (-2.7%) and hotels (-0.1%).  Although inflation is still above the Fed’s 2.0% target, given the lags in monetary policy and slow growth in the M2 measure of the money supply, we believe it’s time for the Fed to consider reducing short-term rates slightly in the months ahead.

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Back during the Financial Panic of 2008, clickbait media kept screaming “Hyperinflation.”  We consistently pushed back against this theme, and argued inflation would not accelerate.  Yes, Quantitative Easing and zero percent interest rates, which Ben Bernanke invented at the time, massively increased the size of the Fed’s balance sheet and boosted cash deposits and reserves at banks as the Fed printed money to buy debt – Treasury bonds, mortgages and other assets.

So why didn’t the QE of 2008-2015 cause inflation?  Because mark-to-market accounting destroyed capital faster than the Fed or Treasury (remember TARP) could boost it.  At the same time, regulators significantly lifted both the capital and liquidity ratios banks were required to hold.  The result: M2 grew at an average rate of 6% per year during the crisis, about the same rate as it did before.

This all changed during COVID. The Fed reduced liquidity rules and the Treasury enlisted banks in issuing direct tax rebates, making PPP loans, and distributing unemployment benefits, which caused M2 to surge.  It was one of the easiest forecasts we have ever made.  When M2 surges, so does inflation.  The CPI consumer price inflation peaked at 9.0% in mid-2022, the highest in roughly forty years.

The surge in M2 stopped in 2022.  Today, M2 is only 0.5% above 2022 peak levels.  Yes, M2 growth has picked up in the past year, but it is still growing relatively slowly, up 4.4% from a year ago, although up at 6.5% annual rate in the past three months.

In the meantime, “real” (inflation-adjusted) short-term rates have been hovering about 2.0% for the past two years the highest, for the longest, since 2006-07. 

It is because of this relative tightness in monetary policy that inflation has slowed, as well.  The annual increase in the CPI has slowed to 2.3% as of April.  Core inflation, which excludes food and energy and which peaked at 6.6%, is now down to a more respectable 2.8%.   There’s a similar story for “Super Core” inflation which also excludes other goods as well as housing rents.

In the past three months, the CPI is up at only a 1.6% annual rate while producer prices are down at a 1.2% rate.   

This week we get updates on consumer and producer prices and, as the table below shows, we expect the reports to show inflation ran a little hotter in May than the three prior months, but not really hot in an absolute sense.  

This strikes many observers and investors as odd, because the Trump Administration’s tariffs have been in effect, although erratic, and should have been having an impact by now.  How can we have lower inflation and higher tariffs at the same time?  

Because, as we’ve been saying all along, the link between tariffs and inflation is overrated.  Yes, the specific items that are tariffed might rise in price, but that means less money left over to buy other goods and services, which reduces those prices.  Tariffs shuffle the deckchairs on the inflation ship, not how high or low the ship sits in the water.  That’s up to the money supply.

None of this suggests the Fed won’t reverse course and fully let down its guard.  In spite of all the progress, we are still above the Fed’s 2.0% inflation target.  Inflation may look gone, but boosting M2 and cutting interest rates sharply could reignite the embers of inflation which are still buried under the ashes from the COVID monetary fire.    

We think the economy overall is ready for a modest cut in rates.  In fact, all interest rates across the yield curve are finally above inflation.  We do not think the interest rate policies of the Fed were appropriate.  Neither the 2008 Panic or COVID were caused by monetary policy, so holding interest rates below inflation never made sense to us.  And, at this point, with the real federal funds rate at 2% there is room for roughly two 25 basis point cuts.  But the Fed is wrongly focused on tariffs, so while rate cuts now are warranted, the Fed is likely on hold until September.

Brian S. Wesbury, Chief Economist 
Robert Stein, Deputy Chief Economist

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Implications:  The headline payroll number beat consensus expectations slightly, but the totality of today’s report on the labor market shows a mixed bag.  Nonfarm payrolls grew 139,000 in May versus a consensus expected 126,000.  However, payrolls were revised down an unusually large 95,000 for the prior two months, leaving the net gain, including revisions, at a tepid 44,000. We like to follow payrolls excluding three sectors: government, education & health services, and leisure & hospitality, all of which are heavily influenced by government spending and regulation (that includes COVID lockdowns and re-openings for leisure & hospitality).  This measure of “core payrolls” increased only 5,000 in May and is up only a grand total of 26,000 in the past three months.  Meanwhile, civilian employment, an alternative measure of jobs that includes small-business start-ups (but is volatile on a month-to-month basis) dropped 696,000 in May.  Given that decline, why did the unemployment rate remain unchanged at 4.2%?  Because the labor force (people who are either working or looking for work), fell 625,000.  In the past four months the labor force is down 234,000, but with the native-born labor force up while the foreign-born labor force is down, a potential sign of the new Administration’s efforts against illegal immigrants.  Another sign of the new Administration is that excluding postal workers and census-related jobs, federal payrolls declined by 16,000 in May, the largest drop for any month in the past twenty years.  Compared to January, this measure of federal jobs is down 47,000, the largest four-month drop since the 1990s.   Long-term, reducing the size of government should help create more jobs in the private sector.  The best news for workers in May was that average hourly earnings rose 0.4% and are up 3.9% from a year ago.  Unfortunately, this may help the Federal Reserve justify postponing any rate cuts until later this year.  In the meantime, the share of unemployed workers who voluntarily left (or “quit”) their prior job dropped to 9.8% in May, the lowest level in four years and much lower than the 13.2% that prevailed in January.  The greater reluctance to leave a job without another job lined up suggests more anxiety on the part of workers about the near-term future.  We think that anxiety is warranted in spite of what is likely to be a strong second quarter for real GDP growth.  The (slight) fall of output in the first quarter and then the surge in Q2 is due to tariff policy, not a real bust-boom cycle.

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Oil markets are once again gripped by volatility as OPEC+ proceeds with its third production hike in as many months—adding 411,000 barrels per day in July—while prices linger near $65 per barrel. In this week’s Three on Thursday, we examine the economics of U.S. shale, focusing on the price levels needed to keep existing wells running and justify new drilling. 

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Implications: The U.S. trade deficit shrunk by a record $76.7 billion to $61.6 billion in April, as exports rose by $8.3 billion while imports plummeted by a record $68.4 billion. Imports jumped at an unprecedented rate in the first quarter as businesses were front-running President Trump’s new tariffs.  Now all that is reversing.  Pharmaceutical imports led the way higher in Q1, and led the way lower in April dropping by $26.0 billion alone for the month.  Because imports subtract from GDP in national accounting, the surge in Q1 became a major drag on growth; net exports alone shaved roughly five percentage points off Q1’s growth rate, pulling real GDP down at a 0.2% annualized pace.  But now, with tariff front-running peaking in March, imports should continue to be unusually soft for the next few months and so trade should add substantially to the GDP calculations for the current quarter.  However, erratic trade policy out of Washington adds a great deal of uncertainty in translating recent trade reports into GDP projections.  Vizion, a global container tracking firm, reported that twenty-foot equivalent unit (TEU) bookings from China to the U.S were down massively in April.  But once the President decided to drop tariffs on most goods from China to 30% from a peak of 145% a large pick up in bookings commenced in May.  Overall, U.S. trade volume (exports + imports) is up 5.7% from a year ago—exports are up 8.6%, while imports have climbed 3.4%.  Meanwhile, the landscape of global trade continues to shift.  China, once the top exporter to the U.S., has fallen to third place behind Mexico and Canada. Also in today’s report, the dollar value of US petroleum exports exceeded imports once again. This marks the 38th consecutive month of the US being a net exporter of petroleum products.  In other news this morning, initial jobless claims rose 7,000 last week to 247,000, while continuing claims fell 3,000 to 1.904 million.  These figures are consistent with our forecast of a 109,000 increase in nonfarm payrolls in May, to be reported tomorrow morning.

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Implications:  The ISM Services index missed consensus expectations in May, slipping below 50 for the first time in almost a year.  Before sounding the alarm, it’s important to remember that these Purchasing Manager’s surveys often capture sentiment mixed in with actual data.  Uncertainty about policy could be impacting them.  Nonetheless, the overall decline in May was driven by an abrupt fall in the new orders index, which moved to the lowest level since late 2022 at 46.4.  Uncertainty surrounding tariffs appears to be the major catalyst, as respondent comments continue to report difficulty in forecasting and planning and look to delay or minimize ordering until the effects become clearer.  This “wait and see” mentality was apparent in the business activity index, which registered an unchanged reading of 50.0 in May, down from 53.7 in April.  Service companies are in turn taking a cautious approach with their hiring efforts, as the index inched into expansion territory at 50.7 after two months of contraction, with an equal number of industries (seven) reporting an increase versus a decrease in employment.  The highest reading of any category was once again the prices index, which rose to 68.7 in May. That’s the highest level since late 2022, but still far from the worst we saw during the COVID supply chain disruptions, where the index reached the low 80s. Though official inflation data show a quiet past three months (PCE prices are now up only 2.1% from a year ago) that does not mean the inflation dragon has been tamed.  If the Fed were to dramatically loosen monetary policy, inflation could come back quickly.  In other news this morning, ADP’s measure of private payrolls increased 37,000 in May versus a consensus expected 114,000. We’re estimating Friday’s official report will show a nonfarm payroll gain of 109,000 with the unemployment rate remaining steady at 4.2%.  In other recent news, cars and light trucks were sold at a 15.6 million annual rate in May, down 9.3% from April, likely affected by buyers front-running tariffs.  Auto sales in spite of recent volatility have been weak and are down 1.1% from a year ago.

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Implications:  Activity in the manufacturing sector continued contracting in May, as the ISM Manufacturing index lagged expectations and fell to a six-month low. However, the details of the report make it surprising that the headline number declined to 48.5 from 48.7, as the major measures of activity moved higher in May.  The overall decline was entirely due to a fall in the inventories index, which dropped to 46.7 after two months of sitting in expansion territory, likely a reversal of the unprecedented surge in imports as companies stockpiled materials before tariffs were enacted (for more info on how that has distorted economic data, see today’s Monday Morning Outlook). Looking at the other details, the production index increased to 45.4 from 44.0, but besides last month, that is the lowest level since the height of the pandemic.  Order books were already weak before this year and the added business uncertainty from tariffs along with government spending cuts are forcing companies to continue revising their production plans downward. In turn this has impacted their hiring efforts, as the employment index remains firmly in contraction, with more than double the industries (nine) reporting lower employment in May versus higher (four).  On the supply chain front, one comment from the Electrical Equipment, Appliances, & Components industry wrote that tariffs alone have created supply chains disruptions rivaling that of COVID. The supplier deliveries index increased to 56.1 in May – a 35-month high – but that is far from the worst we saw during the COVID supply chain disruptions, where the index reached the high 70s.  In other words, supplier bottlenecks are significant, but not nearly as bad as COVID levels.  Finally, the worst part of the report is that inflation remains a problem, even while manufacturing stagnates.  The prices index declined to 69.4, but besides last month that is the highest level since 2022. Not a good sign for the economy.  In other new this morning, construction spending fell 0.5% in April, led by drops in homebuilding, manufacturing, and power projects.

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