The S&P 500 Index has continued to climb this year, but we believe caution is still warranted and that broadening out beyond the market’s largest names remains as important as ever. In today’s “Three on Thursday,” we take a closer look at our Capitalized Profits Model, a framework we use to estimate fair value for the S&P 500 Index. Click the link below to find 
out more.

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Implications: New home construction continued to struggle in August, lagging expectations and falling to a 1.275 million annual rate.  However, the details of the report were stronger than the headline. The 2.6% drop in overall starts was entirely due to the volatile multi-unit category where starts plummeted 21.7%.  Single-family starts rose 7.6% to a five-month high and now stand 5.2% above a year ago, a welcome sign given the conditions homebuilders have faced over the last four years.  Looking at the big picture, home construction has been on a downward trend since peaking a month after the Federal Reserve began the previous tightening cycle back in March 2022 and currently sit at levels reminiscent of 2019.  The key issue for homebuilders remains affordability, which 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 the Federal Reserve raising their short-term interest rate target yesterday for the first time since mid-2023 (click here for more on yesterday’s Fed decision). This has resulted in a reversal of 30-year mortgage rates, which have moved roughly 60 basis points higher since February and now sit around 6.7%, 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 11.9% in August to a 1.128 annual pace, the lowest level in more than seven years.  Given these developments it is no surprise to see the NAHB index (a measure of homebuilding sentiment) declining to 32 in September from 35 in August, where a reading below 50 signals that a greater number of builders view conditions as poor versus good (now the 29th consecutive month that has been the case.)  In other news this morning, initial claims for unemployment insurance declined 10,000 last week to 196,000, while continuing claims declined 39,000 to 1.730 million.  These figures suggest job gains continue. In manufacturing news, the Philadelphia Fed Manufacturing Index, a measure of factory sentiment in that region, fell to +37.8 in September from +47.4 in August.

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The Federal Reserve today unanimously decided to raise its short-term interest rate target by a quarter percentage point to a range of 3.75 – 4.00%, the first hike since mid-2023.  The Fed made two key changes to the statement announcing its decision, declaring that “domestic spending has been resilient” and the rate hike “will support a timelier return” to the Fed’s 2% inflation target.     

In the press conference following the meeting, Chairman Warsh emphasized the strength of the US economy and the potential for an acceleration of that growth have shifted the Fed’s focus to price stability and that inflation has been too high for too long.  

What’s odd about the rate hike is that the Fed was making steady progress against inflation in the few years prior to the Iran War.  The increase in inflation since then is due to a spike in energy prices.  Going into this year the Fed’s “playbook” based on prior economic research was that when inflation moves up temporarily due to a negative supply shock (which is what it is experiencing now in the energy sector) the Fed should hold monetary policy steady, neither tightening nor loosening, until the supply shock runs its course.  Yet now the Fed is instead hiking rates into a negative supply shock, even though higher short-term rates will do nothing to boost energy supply.

On top of this, the “dot plot” released after today’s Fed meeting suggests policymakers will raise rates one more time later this year, with two members signaling no more changes this year, twelve members projecting one more hike (of 25 bps), and four members forecasting two more hikes.  We think one more hike is the most likely outcome, not only because of the dot plots but also because it is very unlikely the Fed will raise rates at the next meeting, which is within one week of the mid-term elections this November. 

Beyond this year, the “median dots” show no rate hikes in 2027, and then one rate cut in each of 2028 and 2029.  This is a less aggressive path for short-term rates than is now embedded in the futures market for federal funds, which suggests one more rate hike this year and then one or two more hikes in 2027.      

In the meantime, the economic projections from the Fed were little changed versus the projections they issued in June, with only slightly faster economic growth and inflation.  The most notable change in the projections from the Fed was perhaps the most subtle, which is that the Fed now anticipates that the long-run average federal funds rate will be 3.2% versus a prior 3.1%, which, if adjusted further upward in future meetings could signal that the Fed is rethinking the level of its ultimate destination for short-term rates once inflation does get to 2.0%.  

It’s also important to recognize that the US economy is significantly split right now between robust growth in the technology sector, which is more insulated from interest rate moves, and weakness in some other sectors like housing, which is rate-sensitive.  As always, we think investors should be paying more attention to the moderately-growing M2 measure of the money supply, which is signaling that year-ago comparison measures of inflation will settle down toward 2.0% once we get more than a year past the early months of the oil price shock.   

Brian S. Wesbury, Chief Economist

Robert Stein, Deputy Chief Economist

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Implications: The resiliency of the US consumer was on display once again in August as retail sales rebounded from a fall in July by rising the most in five months.  Looking at the details, the 1.2% headline advance was broad-based with eleven of the twelve major categories rising for the month.  The gain was led by nonstore retailers, which recovered from an unfavorable comparison month in July after Amazon moved their Prime Day sales event this summer, posting a robust 2.6% gain in August. Gasoline stations also contributed with a 3.1% increase, but that was driven by a rise in gasoline prices over the month and should not be interpreted as a boost in economic activity. The good news was that the modest 0.2% drop in building materials was the only major category to decline.  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 1.3% in August, and if unchanged in September, will rise at a 4.8% annualized rate in the third quarter versus the second quarter average.  This is consistent with our view that third quarter real GDP is growing at about a 3.5% annual rate.  Another bright spot in today’s report came from sales at restaurants & bars (the only glimpse we get at services in this report), which jumped 1.2% in August and has now shown healthy growth over the past five months. It’s important to remember that none of these figures are adjusted for inflation.  Nominal retail sales have risen 6.0% in the past year, but factoring in inflation, “real” inflation-adjusted sales are up 2.6% in the past twelve months. However, the continued resilience of the consumer, alongside inflation that remains above the Fed’s target, reinforces our expectation that the Fed will raise rates at its meeting this afternoon.  In other recent news, the Empire State Index – a measure of factory sentiment in the New York region – dropped to +7.6 in September from +20.6 in August.  On the inflation front, import prices rose 0.7% in August and export prices rose 0.6%.  In the past year, import prices are up 7.0%, while export prices have risen 8.6%.

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A rate hike on Wednesday is now very likely but would also be unusual, and perhaps dangerous, at least as far as the past generation of monetary policy goes.  

Why likely?  Because the US has experienced both above-consensus job growth and above-consensus inflation.  As a result, futures markets are pricing in three to four rate hikes in the next 12 months.  We’re not there yet.

But even one 25 bps hike would be unusual given that the Fed started cutting rates about two years ago.  Rate hikes, in the midst of an easing cycle, are unusual.  Moreover, Fed policymakers believe the long-term neutral federal funds rate is somewhere between 3% and 3.25%, which is below the current target of 3.5% to 3.75%.

Normally, or at least in the past generation, once the Fed starts cutting rates, it keeps cutting rates until rates reached a long-term bottom.  Going backward in time, that is what happened before and during COVID, before and during the Global Financial Crisis, as well as during the collapse of the first internet boom in 2000-02.

All three of these episodes included a recession that the Fed felt it could alleviate.  For now, at least, a recession does not seem to be in the cards so the Fed is less worried about that.  It’s more worried about inflation.

The last time the Fed raised rates during a general rate-cutting cycle was in early 1997 under then-Chairman Greenspan, who justified the one-time quarter-point hike based on strong economic growth that he thought was due to a “wealth effect” from booming stock markets.  Using a Keyneisan approach, the Fed was worried that low unemployment (then just above 5%) could stoke inflation even though it hadn’t happened yet.

This same thing is playing out today.  The unemployment rate is 4.1%, the Atlanta Fed projects third quarter real GDP growth at 4.4%, investment in data centers is soaring, and inflation remains stubbornly high.

All of this is complicated by multiple wars.  Energy prices have spiked because of the conflict in the Middle East while the Ukraine-Russia conflict has reduced global refining capacity.  But, there is nothing the Fed can do about this and hiking rates during war-time is highly unusual.

It’s also important to realize that just because the Fed reduced rates from mid-2024 through late-2025 and was trying to reach a target rate of 3.1% doesn’t mean it will continue to try.  That 3.1% is a guess. 

As Chairman Warsh pointed out in Jackson Hole, AI and the investment in data centers is a wild card.  It could lift productivity growth, which would reduce inflation.  But it could also be over-investment (like fiber optic investment during the late 1990s) that comes to an abrupt end.

One thing is for certain.  The buildout of AI and data centers, which has been rapid, is not as rate-sensitive as the rest of the economy which is not performing nearly as well.  Housing in particular is very weak, and rate sensitive!  In other words, raising rates may not slow AI, but it will impact other areas of the economy.

Another important point is that in 1997, when Greenspan hiked rates, interest rates and the money supply were tied together because the Fed operated under a system of scarce reserves.  Now, with abundant reserves, a rate hike will not directly influence the money supply in the same way.  If rates rise, but the money supply grows, the rate hike will have less impact on inflation than investors (and the Fed) seem to think.

Brian S. Wesbury – Chief Economist

Robert Stein, CFA – Deputy Chief Economist

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Implications: The Fed will likely hike short-term rates at the meeting next week.  Consumer prices matched expectations by rising 0.4% in August, leaving the year-ago comparison unchanged at 3.4%.  “Core” CPI, which excludes food and energy, surpassed expectations and rose 0.3%, with the year ago comparison falling to 2.4%.  Earlier this week, we said that while the strong August jobs report had shifted the odds toward a rate hike, Chairman Warsh may still have enough ammunition to hold rates steady if this week’s inflation data came in more benign than the consensus expected. That did not happen. Although we think the Fed should be focusing on the money supply, not temporary energy price shocks, when deciding where interest rates should go – which suggests they should hold rates steady – August marks the 65th consecutive month that both headline and core inflation were above the Federal Reserve’s official 2.0% target. Combined with the strong labor report this month, we think that will ultimately be enough to push Warsh and the FOMC committee toward their first rate hike in three years.   Looking at the details of the report, energy prices led the index higher, rising 2.1% in August after falling -1.5% and -5.7% in the two prior months, and is now up 16.3% versus a year ago. Core CPI, which excludes food (+0.1% in August) and energy, rose 0.3%, the biggest increase in four months. Housing rents (both those for actual tenants and the imputed rental value of owner-occupied homes) have been the primary contributor to core inflation over the last few years but have been trending toward slower gains in 2026, rising a modest 0.2% in August.  That was surpassed by a 5.9% jump in prices for wireless telephone services despite its much smaller weighting, while airline fares (+2.7% in August) continue to climb higher, up 23.4% in the past year. Prices for hotels (+2.7%), used vehicles (+0.4%), and computers, peripherals & smart-home assistants (+3.8%) also made notable contributions. That was partially offset by declines across categories such as motor vehicle insurance (-0.8%), medical care (-0.2%), and financial services (-1.3%). The worst news in today's report was that wages lost ground in the battle against inflation, as "real," inflation-adjusted hourly earnings declined 0.1%, continuing a trend that has left them down 0.3% over the past year.  The bottom line is that inflation remains elevated.

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Last week, the Bureau of Labor Statistics (BLS) released its preliminary benchmark revision to payrolls for the year ending March 2026. This week’s “Three on Thursday” looks at what changed and what it means for the job market. Curious about the results? Click the link below to find out more.

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Implications: Existing home sales continued to struggle in August, as the recent jump in mortgage rates kept potential buyers on the sideline. Sales declined 2.0% in August and are now at the slowest pace in more than a year. Looking at the big picture, activity has been stuck in low gear since the end of the COVID pandemic, with the annual sales pace hovering around 4.000 million. That is roughly in line with the aftermath of the Great Financial Crisis, and 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 in the aftermath of the conflict with Iran, with higher energy costs having an upward impact on short-term inflation.  The result has been a rapid increase in 30-year mortgage rates, which are up 70 basis points since February and now sit around 6.8%. Buyers are also unlikely to get any help from the Federal Reserve due to recent strength in the US labor market and stubborn inflation putting rate hikes back on the table. However, there is some good news for buyers. Since the COVID pandemic, many existing homeowners have been reluctant to sell due to a “mortgage lock-in” phenomenon, after buying or refinancing at much lower rates before 2022.  This meant that potential buyers had to deal with limited options.  However, the existing home inventory has been improving recently and now sits at the highest level since the pandemic (though still well below pre-COVID levels). Meanwhile, the months’ supply of homes (how long it would take to sell existing inventory at the current very slow sales pace) rose to 4.9 in August, the highest level since 2015 and nearing the benchmark of 5.0 that the National Association of Realtors uses to denote a normal market.  Finally, though the median price of an existing home sits near a record high, it is up only 1.6% versus a year ago. Aggregate wage growth (hourly earnings plus hours worked) has been consistently outpacing median home price gains since early-2025, which gradually improves affordability. While many cross currents remain, the fundamentals for a modest improvement in home sales are starting to emerge.

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Implications: Producer prices rose in line with consensus expectations in August, as the Producer Price Index increased 0.4%.  More than half of the headline increase was due to a 4.2% increase in energy prices.  Excluding energy, producer prices rose a more modest 0.2%.  Looking at the details, both goods prices (+1.1%) and services prices (+0.1%) increased in August.  More than a third of the increase in goods prices was due to a 24.1% rise in diesel prices, reflecting a renewed rise in oil prices as Middle East hostilities continue.  Food prices (+0.1%) and other energy-related categories such as gasoline, jet fuel, and crude petroleum also rose. On the services side, prices rose a modest 0.1% overall, led by a 2.0% increase in truck freight transportation.  Further back in the supply chain, prices for unprocessed and processed intermediate goods rose 1.8% and 1.1%, respectively.  While the rise in processed intermediate goods prices was driven by energy, nearly 60% of the increase in unprocessed intermediate goods can be traced to nonfood materials excluding energy, which are industrial inputs that are neither food nor fuel, such as metal scrap and construction materials. Excluding food and energy, "core" producer prices rose a moderate 0.2% in August, while the twelve-month change was 4.6%, well above the 2.9% increase for the twelve months ending in August 2025.  Overall producer prices are up 5.4% in the past year, double the change from the twelve months ending in August 2025. The pickup in August prices is likely to put more pressure on the Fed to raise rates at next week’s meeting. Futures markets currently imply about a 70% chance of a hike. Part of that figure reflects the fact that the following meeting falls just before the mid-term elections, when policymakers will be careful to be perceived as independent of politics.  In the end, we believe policymakers should focus more on the money supply, which is up 5.4% in the past year versus the 6.0% trend prior to COVID when inflation remained low. We expect this monetary tightness will eventually bring inflation down once the conflict in the Middle East ends.  In other news this morning, initial claims for unemployment insurance declined 1,000 last week to 206,000, while continuing claims also declined 1,000 to 1.774 million.  These figures suggest job gains continue.

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Before Friday’s jobs report, it was roughly a toss-up in the financial markets whether the Fed would raise rates at the next meeting in mid-September.  Now, the odds favor a rate hike and it’s not hard to see why.

Nonfarm payrolls rose 162,000 in August, easily beating the consensus expected gain of 55,000 while payrolls were revised up 55,000 for the prior two months.  Remember the angst a month ago about the economy after July payrolls were originally reported down 23,000?  That negative number has been revised away and is now estimated at +21,000, instead.

But it’s not just payrolls that grew.  Total hours worked in the private sector rose 0.3% in August and are up 1.2% from a year ago.  In fact, in the past six months these hours are up at a 1.6% annual rate. This is important because it suggests the expansion in jobs should continue.  

Many investors remember the “olden days” back in the 1980s and 1990s when payrolls would expand year after year by about an average pace of 275,000 per month, so must be wondering why Friday’s report was perceived as so strong, particularly when the average monthly payroll gain has been only 50,000 in the past year.

But times have changed, particularly since January 2025.  As we have noted several times before – right or wrong, for better or for worse – the US has shifted from an extremely loose immigration policy to an extremely tight one.  And if net immigration (legal plus illegal) is roughly zero (or less!) while the native-born population ages, then the labor force is going to grow very slowly, meaning payroll growth will grow slowly, as well.

However, a rate hike later this month is far from a done deal or a slam dunk.  We get two inflation reports later this week, on consumer and producer prices, and if those come in more benign than the consensus expects, that may give Chairman Warsh enough ammunition to keep rates steady.

Another reason rates may hold steady is that wage growth has been tame.  Average hourly earnings rose 0.3% in August and are up only 3.1% from a year ago.  In the past six months, average hourly earnings are up at only a 2.6% annual rate.  If the Fed is targeting 2.0% inflation and productivity growth is in the 1.5 – 2.0% range then wage growth in the 3.5 – 4.0% range should be acceptable at the Fed, and yet recent wage growth is even slower than that!

This is one of those data sets that could help both supply-siders and Keynesians resist a rate hike.  For supply-siders it suggests AI is helping boost the demand for labor.  But increases in the demand for workers that reflect more production shouldn’t be inflationary.  That’s what also happened in the 1990s during the first internet boom and was a reason why then-Chairman Alan Greenspan resisted rate hikes. 

At the same time, the efficiencies created by AI may be holding down overall wage growth even though the Trump Administration’s immigration policies are limiting the labor pool.  Overheating this is not.

In turn, all of this is consistent with the monetarist view that policymakers need to focus more on the money supply, which has grown modestly the past few years and suggest that once we get past the initial energy shock related to the Iran War that inflation should subside anyhow, without further tightening.    

In the end, the Fed’s decision next week may come down to election timing.  The next meeting after September is scheduled one week prior to the mid-term elections, which means policymakers will be more eager than usual to avoid controversy.  And it would be hard to raise rates in October even if economic conditions warrant a hike by then, some might press for an earlier hike in September just to get it out of the way.

Brian S. Wesbury – Chief Economist

Robert Stein, CFA – Deputy Chief Economist

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