In this week’s installment of “Three on Thursday,” let’s explore some of the dynamics surrounding the United States dollar. In an era of inflation, massive debt, large deficits, and threats of tariffs, there are persistent rumors circulating that the dollar is at risk of losing its reserve currency status. 

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Implications:  US homebuilding continues to whipsaw as builders deal with all sorts of headwinds, tailwinds, and crosswinds. After unusually cold weather and California fires held back homebuilding in January, new home construction rebounded sharply in February, topping even the most optimistic forecast from any economics group surveyed by Bloomberg.  Then in March, homebuilding contracted by the most in a year, falling 11.4% to a level even lower than the weather-constrained month of January.  Already hamstrung by high home prices and relatively high mortgage rates, builders must now contend with the uncertainty of new tariffs and how they’ll impact their building costs.  Looking at the details, single-family construction led the decline, falling 14.2%, the biggest decline for the category since the COVID lockdown. The overall drop was split amongst regions, with the South and West responsible for the entirety of the decline (homebuilding in the Midwest and Northeast rose in March).  Looking at the trend, home construction has stagnated in recent years, with starts down 1.3% compared to two years ago and hovering around levels reminiscent of 2019.  That said, it appears that part of the reason why homebuilding has lagged is due to builders focusing on completing projects.  Home completions declined 2.1% in March, but the 1.549 million annual pace was faster than all but two months from 2020-2023.  Moreover, completions have run above a 1.5 million pace (our estimation of annual homes needed to keep up with population growth and scrappage) in eleven out of the last twelve months.  With strong completion activity and tepid growth in starts, the total number of homes under construction continues to fall, down 15.2% in the past year.  That type of decline is usually associated with a housing bust, but we don’t see that happening.  With the brief exception of COVID, the US has consistently started too few homes almost every year since 2007.  As a result of the shortage of homes, we think housing is far from a bubble and expect housing prices to continue higher in 2025 in spite of some broader economic headwinds.  In other recent housing news, the NAHB Housing Index (a measure of homebuilder sentiment) ticked up to 40 in April from 39 in March.  On the employment front, initial jobless claims fell 9,000 last week to 215,000, while continuing claims rose 41,000 to 1.885 million.  These figures suggest moderate job growth in April.  Finally, the Philadelphia Fed Manufacturing Index, a measure of factory sentiment in that region, dropped -26.4 in April from 12.5 in March.

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Implications:  March’s report on industrial production doesn’t include any glimpses of what happened after “Liberation Day,” but it shows that factory activity continued to expand despite tariffs going into effect on Canada, Mexico, as well as other specific products. Yes, overall industrial production declined 0.3% in March. However, that entire decline was driven by a 5.8% drop in utilities output that the Federal Reserve points out was the result of warmer than normal weather reducing the demand for home heating. Every other major category increased in March. The manufacturing sector was the biggest source of strength, rising 0.3% to post a fifth consecutive gain.  Looking at the details, auto production jumped 1.2% for the month.  Given the amount of activity that happens in the auto industry across the US southern border, we expect trade negotiations with Mexico to heighten volatility in this sector going forward.  Meanwhile, non-auto manufacturing (which we think of as a “core” version of industrial production) increased a healthy 0.3% in March, and has risen four months in a row. Another notable gain in this “core” measure came from the production in high-tech equipment which rose 0.3% in March, likely the result of investment in AI as well as the reshoring of semiconductor production.  High-tech manufacturing is up 11.3% in the past year, the fastest pace of any major category.  The mining sector was also a source of strength in March, rising 0.6%.  A faster pace of metal and mineral extraction and drilling for new wells more than offset a decline in gas and oil extraction for the month (which was due to normal monthly volatility). Gas and oil production are up 2.4% in past year. Look for an upward trend in activity in this sector in 2025 as the Trump Administration takes a more aggressive stance with permitting.  In other recent news, the Empire State Index, which measures manufacturing sentiment in the New York region, rebounded to -8.1 in April from -20.0 in March.

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Implications:  Retail sales soared in March as consumers scramble to front-run potential tariffs.  Looking at the headline, the 1.4% jump in overall sales was the largest monthly increase in more than two years, led by a 5.3% surge in auto sales (one of the sectors expected to be hit the hardest by tariffs).  Excluding autos, sales rose 0.5%, while previous months’ activity was revised substantially upward.  Building materials – another category expected to be impacted by new tariffs – also showed an outsized gain, rising 3.3%, the largest increase for the category in four years.  Overall, eleven out of thirteen major categories rose in March, with sales at gas stations (-2.5%) and furniture stores (-0.7%) showing the only declines.  We like to follow “core” sales, which excludes the often-volatile categories for autos, building materials, and gas.  That measure rose 0.6% and was up a robust 1.3% including revisions.  Core sales are up 4.6% in the past year but have been slowing in 2025: up at a 3.0% annual rate in the first quarter, even after the March bump from tariff front-running.  The good news is that sales at restaurant & bars – which have been dragging lately – jumped 1.8% in March, matching the largest monthly increase for that category since October 2022.  We watch this category closely since it is the only glimpse we get at services in the retail sales report – the sector that drives two-thirds of the US economy.   As a whole, retail sales are up 4.6% on a year-to-year basis.  However, “real” inflation-adjusted retail sales are up 2.1% in the past year and are still down from the peak in early 2021.  This highlights the ugly ramifications of inflation: consumers are paying higher prices today but taking home fewer goods than they were four years ago.  Going forward, we expect retail sales to remain choppy as consumers try to make heads and tails of what may come next in the constantly shifting environment.  In other recent news, import prices declined 0.1% in March while export prices were unchanged.  In the past year, import prices are up 0.9% while export prices are up 2.4%.

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Quantitative Easing was different during COVID than during the Financial Panic of 2008.  During COVID, M2 growth soared, while it was held back during the Financial Panic by much tighter liquidity controls on banks.  That’s why we were among the first and very few who predicted much higher inflation due to COVID policies.

After that, we remained wary of loosening monetary policy too aggressively because we feared that, in spite of a drop in inflation, inflation remained above the Federal Reserve’s 2.0% target and the embers of higher inflation could be rekindled quickly if the Fed were too hasty.

But recent inflation reports suggest some modest room for loosening monetary policy, including a reduction in short-term interest rates.  In spite of some new tariffs, consumer prices declined 0.1% in March, the largest decline for any month since the early days of COVID.  As a result, consumer prices were up only 2.4% in March versus a year ago and it looks like the Fed’s preferred measure (PCE prices) is up about 2.2% in March compared to a year ago, which is very close to the 2.0% target.

Yes, we are still above 2.0%, but monetary policy operates with long and variable lags.  So, if we maintain a monetary policy tight enough to bring inflation down to 2.0%, and if we also wait until inflation hits 2.0% before ending that tighter monetary regime, then we are almost guaranteeing that inflation will fall short of that 2.0% target for some period of time and could raise medium-term recession risk.

The same M2 measure of money that signaled high inflation several years ago is only up 3.9% in the past year.  By contrast, M2 grew at about a 6.0% annual rate in the ten years before COVID, and that was during a period when PCE inflation averaged 1.5% per year.  In other words, there’s a case to be made that monetary policy should be looser so that M2 could grow faster than it has in the past year.

Unlike some other analysts and investors, we are not concerned that tariffs will lead to much higher inflation, as inflation ultimately depends on monetary policy, not tariff or tax rates.  Yes, tariffs could increase the price of the particular items being tariffed.  But that means less money would be left over to buy other goods and services, so demand – and prices – typically fall, leaving the overall price level roughly the same as it would be in the absence of tariffs.

However, tariffs could temporarily depress economic growth as they leave consumers and businesses with less to spend on domestically produced goods and services.  In theory, tariffs mean producers should shift some of their output toward being made in the US, but in the short-term businesses may balk at such a shift if they think the tariffs will just be repealed soon anyhow.  In other words, if we are going to impose tariffs, it’s better to impose a tariff system that’s sustainable than one that changes year to year, much less week to week or day to day.

On balance, that suggests some modest room for the Fed to cut short-term rates when it meets in May, although we think the Fed will probably kick the can down the road and make the decision in June.

Don’t get us wrong; we are not changing our view that inflation remains a long-term problem that the Fed must be prepared to fight.  We expect inflation to average 2.5%+ in the next ten years, not the 1.5% like it did pre-COVID.  But short-term risks are to the downside, and we think the Fed should temporarily focus on that.

We also think it’s important for the Fed to move gradually.  The US dollar has weakened lately, and, as a result, there is little case for a drastic loosening of monetary policy.  The Fed could let up somewhat on bank regulations and capital requirements, which would help the struggling bond market.  And one or two rate cuts would not be excessive.

Brian S. Wesbury – Chief Economist

Robert Stein, CFA – Deputy Chief Economist

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Implications:  Producer prices fell in March for the first time since October 2023.  While near constant conversations about rising inflation threats from tariffs echo across the media, prices moved in the opposite direction for both consumer and producer prices in March.  Falling energy prices were a key driver, with an 11.1% drop in gasoline costs leading overall energy prices down 4.0%.  Meanwhile food prices also fell in March, down 2.1%.  But while goods prices as a whole declined a notable 0.9% on the month, goods prices outside of these two typically volatile categories rose 0.3% for the month.  Service prices declined 0.2% in March but remain up 3.6% in the past year, as final demand trade services (think margins received by wholesalers) declined 0.7%, and final demand trade, transportation, and warehousing services fell 0.6%.   Put goods and services together, and overall producer prices fell 0.4% in March but are still up 2.7% versus a year ago, while “core” producer prices – which exclude the often-volatile food and energy categories – are up 3.3% in the past year, a notable acceleration from the 2.3% reading for the twelve months ending March 2024.  The months ahead could very well be volatile for both the markets and the economic data.  Companies have been altering purchasing plans as they try to make heads and tails of what may come next in the constantly shifting environment, but reciprocal tariffs weren’t announced until April, so the March data received to-date is more reflective of the steel and aluminum tariffs, higher tariffs on China, and uncertainty of what was to come, rather than realized tariff costs on a broader set of nations. None of this is making the Fed’s job any easier.  Monetary policy operates with a lag, and the Federal Reserve will be closely watching to see how the rate cuts of late last year translate through the system as they determine if, and when, the next move in rates is appropriate.

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Last Friday, the S&P 500 Index touched our year-end target of 5,200. So, where do we go from here? In today’s “Three on Thursday,” we revisit our Capitalized Profits Model, a framework we use to gauge fair value for the S&P 500 Index. 

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Implications:   Inflation cooled broadly in March despite widespread concerns about tariffs and how they will affect prices.  Looking at the headline, consumer prices fell 0.1% in March versus a consensus expected gain of 0.1%, the first outright monthly decline since the COVID lockdowns.  That led the twelve-month reading to drop from 2.8% to 2.4%, matching the low it set back in September.  Although reciprocal tariffs were not announced until April, keep in mind that the US began collecting tariffs on steel and aluminum, as well as higher tariffs on imports from China, back in March.  Looking at the details, the volatile category for energy led the decline, dropping 2.4% in March as gas prices fell 6.3%.  Food prices rose 0.4%, but it’s important to note these two often-volatile categories have not been what’s kept inflation from returning to the Fed’s 2.0% target.  “Core” prices, which strip out food and energy, rose 0.1% in March, with the twelve-month reading falling to 2.8%, which is above overall inflation.  The good news is that is the first twelve-month core reading below 3.0% since the great inflation scare began back in 2021.  The main driver of core inflation has been housing rents, which continue to outpace most categories (+0.4% in March), though not as much as in the years prior.  Some analysts – including those at the Fed – have argued that housing rents have artificially boosted inflation due to the way it’s measured.  But a subset category of prices that Fed Chair Jerome Powell said back in 2022, “may be the most important category for understanding the future evolution of core inflation” – known as the “Supercore” (which excludes food, energy, other goods, and housing rents) – has been running hotter than headline and core inflation, up 2.9% in the past year.  The good news is this measure fell 0.2% in March.  Notable decliners within the Supercore category were prices for airline fare (-5.3%), hotels and motels (-4.3%), and motor vehicle insurance (-0.8%).  Although inflation continues to run above the Fed’s 2.0% target, given the lags in monetary policy and slow growth in the M2 measure of the money supply, it may be time for the Fed to give more consideration to reducing short-term rates in the months ahead.  In other news this morning, initial jobless claims rose 4,000 last week to 223,000, while continuing claims fell 43,000 to 1.850 million.  These figures are consistent with continued job growth in April, but at a slower pace than in 2024.

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The Federal Reserve started raising short-term interest rates three years ago and the M2 measure of the money supply – what Milton Friedman said to focus on – soon started declining, hitting bottom in late 2023.

One of the great mysteries of the past two years is why, given tighter money, economic growth didn’t slow down, much less hit a recession.  One reason was that the federal government was engaging in the most reckless deficit spending in our lifetimes.  Don’t get us wrong, we don’t believe government spending is good for the economy in the long-run.  But, in the short-run, it can make things feel better.

The federal deficit was north of 6.0% of GDP in both Fiscal Year 2023 and 2024.  To put that in perspective, during the 1980s, President Reagan was consistently criticized for running overly large budget deficits.  And yet the largest deficit of the 1980s was 5.9% of GDP in FY 1983, even as Reagan was fully funding the Pentagon at the height of the Cold War and the unemployment rate was 10%, meaning spending on unemployment and welfare were elevated.

There were no similar excuses for the past two years, when the jobless rate averaged less than 4% and we aren’t at war.  We think the enormity of these deficits, relative to economic conditions, temporarily masked or hid some of the pain from the tightening of monetary policy.

But now fiscal policy has gone in reverse, unmasking that economic pain.  The Trump Administration is cutting government spending, via DOGE and otherwise, while simultaneously raising taxes via higher tariffs.  According to the Tax Foundation, the Trump tariffs – those recently announced plus those already implemented – would raise revenue by 0.85% of GDP, making them the largest peacetime tax increase since 1982, even larger than the Bush tax hike of 1990, the Clinton tax hike of 1993, or the tax increases enacted under Obama.  Note that the Tax Foundation’s score is static, in the sense that it assumes no major shift in the location of production or buying habits back to the US, so that 0.85% estimate could easily be too high, but only time will tell.

Regardless, at least in the short term, these new tariff increases could more than fully outweigh an extension of the 2017 Trump income tax cuts, because most of what gets enacted later this year is likely to just be an extension of current policy.  In other words, unless the income tax law enacted later this year includes a substantial deepening of the 2017 tax cuts, the total burden of taxes will be higher in 2026 than in 2024.

Hopefully the new US tariffs are a prelude to lower trade barriers against US products abroad, in which case our tariffs can come down, as well.  We are hopeful on that front.  But the formula used to calculate the new tariffs – based on our trade deficit with each country rather than the level of their tariffs – suggests that other countries simply reducing their tariffs might not be enough for the Trump Administration to relent on higher tariffs.

In the meantime, the economy has suddenly shifted from being artificially held up by overly large budget deficits to being exposed to temporary pain.  Right now, it looks like US Real GDP will be roughly flat to down in the first quarter (initial release on April 30).  And now consumers have to pay more for foreign goods, at the same time that businesses that might think of avoiding tariffs by putting or expanding operations in the US have to worry about how long the new tariff policies will stay in place.  Why build a new plant here if the tariffs might be gone by the time you finish?  As a result, recession risk is rising and we already thought a recession was overdue earlier this year.

Obviously, the tariffs have been the catalyst behind the recent drop in stock prices.  And stocks may go lower from here.  But stocks were overvalued even before the tariffs and if tariffs weren’t the trigger for the drop in stocks, something else would have been.  That’s why we were willing to stick our necks out late last year and forecast 5,200 on the S&P 500 for this year while the rest of the industry was telling their clients stocks were headed higher.

Depending on the outlook for earnings, the S&P 500 is now basically at fair value, a major change from where it’s been for the past few years.

Brian S. Wesbury – Chief Economist

Robert Stein, CFA – Deputy Chief Economist

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Implications:  Tariffs may be the big story in the news, but the US labor market continued to shrug off uncertainty in March, adding more jobs than even the most optimistic forecast by any economics group surveyed by Bloomberg.  Nonfarm payrolls grew 228,000 for the month, and even after factoring in large downward revisions to prior months rose a healthy 180,000, beating the consensus expected gain of 140,000.  A large part of the gain came from education and health services, up 77,000.   Meanwhile, jobs at restaurants & bars rose 30,000.  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).  In what is probably the best news for March, this “core” measure of jobs rose 89,000, beating the 36,000 monthly average in the past year.  Meanwhile, civilian employment, an alternative measure of jobs that includes small-business start-ups increased 201,000.  Given these job increases, why did the unemployment rate tick up to 4.2% versus 4.1% in February?  Because the labor force (people who are either working or looking for work), rose 232,000.  Other details in today’s report suggested moderate economic growth through March, but reasons for the Federal Reserve to be cautious about cutting short-term interest rates.  Total hours worked increased 0.2% in March and are up 0.6% in the past year.  Add that gain in hours worked to the trend growth rate in productivity (output per hour) of 1.8% per year in the past decade and you get close to 2.5% economic growth.  Meanwhile, average hourly earnings rose 0.3% in March and are up 3.8% in the past year, still higher than the 3.5% we think the Fed would like to see.  Notably, it looks like DOGE continued to make progress in reducing federal government payrolls in March, with jobs falling 4,000 on the heels of a decline of 11,000 in February. This is the first consecutive drop since 2022, and the BLS points out that employees on paid leave or receiving severance aren’t included in these declines. Given the Trump Administration’s goal of reducing the federal workforce, we expect more of this in the months ahead, potentially much more.  That may cause some short-term pain for the US economy, but we expect long-term gains from reducing the size and scope of the federal government, including more jobs gains in the private sector.  In other recent news, cars and light trucks were sold at a 17.8 million annual rate in March, rising 11% from February and 13.3% higher than a year ago. That’s the largest monthly gain in two years, as consumers tried to front-run tariffs on foreign cars.

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