Implications:  Before we dive into incomes and spending, today’s report includes the Fed’s preferred measure of inflation.  PCE prices rose 0.2% in July and are up 2.5% in the past year compared to a 3.3% gain in the year ending in July 2023.  “Core” prices, which exclude the ever-volatile food and energy categories, also rose 0.2% in July and are up 2.6% versus a year ago, a big improvement from the 4.2% reading for the twelve months ending July 2023.  While core price inflation has now stalled for three months at 2.6% on a year-ago basis, it has been enough progress for the Fed to signal it will start cutting rates next month.  Transitioning to a focus on how consumers fared in July shows healthy growth.  Personal income rose 0.3% in July and is up 4.5% in the past year.  Private-sector wages and salaries led the way, up 0.3% on the month and up 3.8% in the past year.  Unfortunately government activity continues to run hot as well, with government transfer payments rising 0.3% in July while government pay rose 0.4% and is up 7.6% in the past year, hovering near the largest twelve-month increase in more than three decades. We don’t think the growth in government pay – or massive government deficit spending – is sustainable or good for the US economy.  Consumer spending rose 0.5% in July, led by outlays on services which rose 0.4% on the month and are up 6.8% in the past year.  Goods spending rose a faster 0.7% in July (but represents a smaller portion of overall consumer spending compared to services) and is up 2.3% from a year ago.  When adjusting for inflation, consumption rose a healthy 0.4% in July.  We are closely watching the service sector as the driver of consumer activity both now and in the near future, and we expect activity to temper as elevated interest rates and continued inflation pressure take a toll.  We are also keeping an eye on the savings rate (the percent of disposable income that consumers save), which hovered around 6.0% pre-COVID, skyrocketed with the excess money printing during COVID, and has now been hovering around 3.0% in recent months.  This shortage in savings will catch up with consumers down the road. In other recent news, pending home sales, which are contracts on existing homes, fell 5.5% in July following a 4.8% jump in June. Plugging these figures into our model suggests existing home sales, which are counted at closing, will decline slightly in August.

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In this week’s Three on Thursday, we explore what happened in the preliminary set of revisions to payroll growth and its implications for jobs. These revisions provide a more accurate picture of job growth, as they’re based on state unemployment insurance tax records from the Quarterly Census of Employment and Wages (QCEW).  While the QCEW takes time to put together, it’s more comprehensive than the monthly payroll data, which only covers 119,000 establishments. Curious about the results?

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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 rose 1.7% in the second quarter vs. the first quarter and are up 8.0% from a year ago.  Leading the increase were profits from domestic industries, which rose 2.7% from the previous quarter.  Profits from the rest of the world fell in the second quarter by 3.5%.  Financial industry data include the Federal Reserve (either profits, or losses) and because the Fed pays private banks interest on reserves, and has raised interest rates, it has been generating unprecedented losses in recent quarters.  Excluding the losses at the Fed (because we want to accurately count profits in the private sector), overall corporate profits were up 1.3% in the second quarter and up 6.4% from a year ago.  Plugging in non-Fed profits into our Capitalized Profits Model suggests stocks remain overvalued. Looking at the other details of today’s report, second quarter real GDP was revised upward to a 3.0% annual rate versus a prior estimate of 2.8%.  The upward revision was all due to more personal consumption in services and non-durable goods. This increase offset small downward revisions in all other major categories. To focus on sustainable growth drivers, we follow "core" GDP, which includes consumer spending, business fixed investment, and home building, while excluding government purchases, inventories, and international trade, which are too volatile for long-term growth. “Core” GDP increased at a 2.9% annual rate in Q2, higher than the prior estimate of 2.6%.   We also got a first look at the Q2 total for Real Gross Domestic Income, an alternative to GDP that is just as accurate. Real GDI rose at a 1.3% annual rate in Q2 and is up 2.0% versus a year ago.  In other words, GDI suggests today’s report may overstate growth a little.  On the inflation front, the GDP price index was revised slightly higher to a 2.5% annual rate in Q2 versus a prior estimate of 2.3% and up 2.6% from a year ago, both above the Fed’s 2.0% target.  In other news this morning, initial claims for unemployment insurance fell 2,000 to 231,000 last week, while continuing claims increased 13,000 to 1.868 million.  On the housing front, home prices were mixed in June. The Case-Shiller index increased 0.2% for the month and is up 5.4% from a year ago; the FHFA index ticked lower by 0.1% in June but is up 5.2% from a year ago.   In the manufacturing sector, the Richmond Fed index fell to -19 in August from -17 in July.  Also, the Federal Reserve released monthly figures on M2, showing it up 0.1% in July and up 1.3% in the past year.  M2 surged during COVID, then declined from early 2022 through early 2023.  It has stopped declining, but isn’t rising rapidly, which should put continued downward pressure on the growth rate of inflation and nominal GDP.

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Implications:  Orders for durable goods surged 9.9% in July, but the gap between this headline and the weaker details of the report was enormous.  The 9.9% headline gain was the largest monthly rise since July 2020, but it was all due to extremely volatile aircraft orders, which soared closer to normal after plummeting in June.  Excluding the transportation sector, orders for durables declined 0.2% in July, were revised lower for prior months, and are up only a modest 0.6% in the last year, failing to keep pace with inflation.  Primary metals led non-transportation orders lower in July, down 0.9% in July, while computers and electronic products (-0.7%), and electrical equipment (-0.4%) also declined.  Fabricated metal products (+0.2%) was the lone other category to rise, while machinery orders were unchanged.  The most important number in the release, core shipments – a key input for business investment in the calculation of GDP – fell 0.4% in July and, if unchanged in August and September, would decline at a 2.4% annualized rate in Q3 versus the Q2 average, which would match Q2 for the largest single-quarter decline since the COVID shutdowns in 2020.  This is the third consecutive month that core shipments have declined, and the fifth time in six months, a clear sign that all is not well on the economic front. Shipments have moderated significantly since surging in late 2020 when PPP loans and stimulus payments flooded the system, and have now declined in two of the last three quarters.  While GDP readings continue to run positive, we expect the trend of turbulent readings to continue as the economy feels the lagged effects of the Federal Reserve’s tightening of monetary policy.

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We all knew it was coming…and in Jackson Hole, Federal Reserve Chairman Jerome Powell said it will come next month.  He said, “the time has come,” and the futures markets have priced in either a 25 or 50 basis point rate cut at the meeting on September 18.

While the world seems to think the setting of the federal funds rate is the most important decision in monetary policy, we don’t think that’s true.  With the advent of the abundant reserve policy in 2008, the Fed separated the link between the money supply and interest rates.

In reality there are multiple things we watch to determine the stance of monetary policy.  Interest rates are one, but the rate of growth in M2 is more important…and that growth rate can now be influenced by what the Treasury Department does with the $730 billion it holds at the Fed in something called the Treasury General Account (TGA).

We think the real reason inflation has slowed is because the Fed actually allowed M2 to decline after the massive increase during COVID.  Yes, short term interest rates were very low.  But it wasn’t those low rates that caused the inflation, otherwise short-term rates that were just as low in the aftermath of the 2008-09 Financial Crisis would have caused a similar surge in inflation.

Similarly, it wasn’t the hikes in short-term interest rates that brought inflation back down.  It was the slowdown in M2, in part caused by the growth of the TGA, which the government has used to take roughly $700 billion out of circulation.

This new system of abundant reserves and a large TGA has pushed the US very close to Modern Monetary Theory, where the Treasury can take money out of circulation by borrowing or taxing from the public and then hiding it in the TGA.  And the Treasury could always drain the TGA and push $700 billion back into circulation by spending.

We don’t know exactly what the Treasury or Fed will do with Quantitative Easing/Tightening and the TGA, but many seem to believe cutting rates will allow the US to avoid a hard landing.  With M2 barely growing, this may not work.

Since 2008, the Fed has held short-term interest rates below inflation 80% of the time, and for nine years, interest rates were basically held at zero.  With inflation running 2.5% to 3.0%, the Fed could take the federal funds rate down a full percentage point to roughly 4.5% and rates would be “normal,” unless and until inflation falls further.

Meanwhile, the housing market is probably not poised to surge as short-term interest rates start to decline.  Mortgage rates are not going to fall back to 3%.  In addition, when the Fed starts cutting rates and people think they will cut them more, they could hold back on purchases waiting for the even lower rates.  So sometimes, rate cuts can lead to slower growth in the near term.  Also, we have a presidential candidate suggesting a large tax credit for some buyers, which could also postpone purchases into next year.

The Fed has been running an experiment in new monetary policy…in other words, don’t start believing that this change in direction from higher for longer, to lower is the way to stick the landing.  We still haven’t felt the full pain from policies undertaken during COVID lockdowns…it takes a lot of imagination to believe all this can happen with no real negative impact.

We are worried that we have come very close to state-run capitalism.  In the past year, 82% of all net new jobs have been in government, healthcare and education.  Growing budget deficits have been holding up the economy even though the money supply has gone negative.  Now, with deficits no longer rising as rapidly, the Fed will try to become the engine behind growth.

But pushing growth with government spending and Fed policy is a dangerous mix that could ignite the embers of inflation before the fire is completely put out.  Gold rose to a record high last week, Bitcoin rallied too.  The markets are not convinced that inflation has been tamed.   

Brian S. Wesbury – Chief Economist

Robert Stein, CFA – Deputy Chief Economist

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Implications:  New home sales surged in July, easily beating consensus expectations and posting the largest monthly gain in nearly two years.  However, while the 10.6% increase in July did push sales to the fastest pace since May 2023, that is roughly the same pace from 2019 before COVID.  Now, with Federal Reserve Chair Jerome Powell all but confirming this morning that rate cuts will begin next month, a new upward trend may be starting for sales.  Thirty-year fixed mortgage rates have already fallen roughly 70bps over the past couple months in anticipation of rate cuts, likely a reason for the large gain in sales in July.  New home sales are a more timely barometer of the housing market because they are calculated when contracts are signed while existing homes are only counted after the sale is closed. Another piece of good news for potential buyers is that the median sales price of new homes has fallen 6.6% from the peak in 2022. It does look like a small part of this decline reflects a lower price per square foot as developers cut prices.  The Census Bureau reports that from 2022 to 2023 (the most recent data available) the median price per square foot for single family homes sold fell 1.1%. While that decline is modest, it represents a stark reversal from the 45% gain from 2019 to 2022.  That said, most of the drop in median prices is likely due to the mix of homes on the market including more lower priced options as developers complete smaller properties. Supply has also put more downward pressure on median prices for new homes than existing homes.  The supply of completed single-family homes is up over 200% versus the bottom in 2022. This contrasts with the market for existing homes which continues to struggle with an inventory problem, often due to the difficulty of convincing current homeowners to give up the low fixed-rate mortgages they locked-in during the pandemic.  In combination with more affordable financing, the abundance of inventories giving potential buyers a wider array of options will help fuel a rebound in new home sales.  One problem with assessing housing activity is that the Federal Reserve held interest rates artificially low for more than a decade, and buyers started to believe those low rates were normal.  With rates now reflecting true economic fundamentals, the sticker shock on mortgage rates for potential buyers is very real.  However, we have had strong housing markets with rates at current levels in the past, and as long as the job market remains strong and buyers understand that the past was a mirage, it’s possible they will eventually adjust.  

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In this week’s Three on Thursday, we explore the current state of indebtedness and financial health of U.S. households. Each quarter, the Federal Reserve Bank of New York provides a comprehensive overview of consumer borrowing and repayment trends, drawing from a nationally representative sample of Equifax credit reports. Curious about the latest trends? 

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Implications:  Existing home sales rose for the first time in five months in July, but still remain near the slowest pace since the aftermath of the 2008 Financial Crisis. It looks like the housing market remains stuck in low gear due to affordability. First, sales are still facing headwinds from mortgage rates that remain relatively high versus recent history. The good news is that 30-year fixed mortgage rates have fallen roughly 70bps over the past several months in anticipation of Federal Reserve rate cuts starting in September. However, while that decline was likely a reason for July’s modest 1.3% gain in sales, some buyers will continue delaying purchases until after the Fed actually delivers. Second, home prices are rising again with the median price of an existing home up 4.2% from a year ago.  Assuming a 20% down payment, the rise in mortgage rates since the Federal Reserve began its current tightening cycle in March 2022 amounts to a 40% increase in monthly payments on a new 30-year mortgage for the median existing home.  Eventually, the housing market can adapt to these increases but continued volatility in financing costs will cause some indigestion. Notably, sales of homes priced at $1 million and above have risen 26.5% in the past year versus a decline of 2.5% for all existing home sales. This demonstrates that, at least at the higher end of the market, both buyers and sellers are beginning to adjust to the new reality of higher rates. However, outside the most expensive segment many existing homeowners remain reluctant to sell due to a “mortgage lock-in” phenomenon, after buying or refinancing at much lower rates before 2022.  This remains a major impediment to activity by limiting future existing sales (and inventories).  However, there are signs of progress with inventories rising 19.8% in the past year.  That has helped push the months’ supply of homes (how long it would take to sell existing inventory at the current very slow sales pace) up to 4.0 in July, near the highest since May of 2020 although still below the benchmark of 5.0 that the National Association of Realtors uses to denote a normal market.   A tight inventory of existing homes means that while the pace of sales looks like 2008, we aren’t seeing that translate to a big decline in prices.  In other news this morning, the Kansas City Fed Manufacturing Index, a measure of factory activity in that region, rose to a still weak -3 in August from -13 in July.  Finally, in employment news this morning, initial jobless claims increased 4,000 last week to 232,000. Meanwhile, continuing claims also rose 4,000 to 1.863 million.  These figures suggest some continued job growth in August, but at a moderate pace.

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Unfortunately, when it comes to the government, what’s old is sometimes new again.

Back in the late 1960s and 1970s the Federal Reserve printed too much money relative to Real GDP, resulting in repeated bouts of high inflation.  President Nixon, having been burned by a mild recession in 1960 the first time he pursued the presidency, wanted to make sure there was no hint of recession in 1972, the year he’d be seeking re-election.  

As a result, in 1971, when Nixon closed the “gold window” at the Fed – to give the Fed the chance to print money more freely – he also imposed wage and price controls to try to temporarily hide the inflation that would inevitably result.  After the election the controls went away and inflation surged, averaging more than 9% per year from 1973 through 1975.  No wonder Nixon got so unpopular after the election!

But price controls have a long and sordid history all over the world, including in ancient Egypt, Babylon, as well as ancient Rome and even modern-day Zimbabwe and Venezuela.  During the French Revolution, in 1793, the rapid inflation caused by the paper money issued under the revolution led to price controls enforced by the death penalty, then implemented by the guillotine.  But even lopping off heads didn’t fix the problem and shortages were one of the damaging results.

Why do governments periodically do this?  Because inflation is political kryptonite.  Prior to COVID the US had inflation under control for almost forty years.  Now, with inflation having remained stubbornly high the past few years – even though it’s decelerated the last two years – some politicians feel compelled to act, especially because while the rate of inflation is down, the price increases of recent years are still in place.  

Politicians say it couldn’t possibly be their fault prices went up too fast, it must be someone else’s, like those wicked “price gougers’ in the private sector, lining their pockets with workers’ hard-earned dollars.  But if price gouging is the reason for recent inflation, why weren’t these gougers doing it the past forty years?  What changed?

And why has the inflation been such a global phenomenon?  Inflation surged around the world, not only in the US.  Is every single company in the world price gouging, and if so, doesn’t that present a once in a lifetime opportunity for someone to take market share by reducing prices?

Meanwhile, the cost of government has soared but those who accuse the private sector of price gouging are ignoring that.  Since 2012, Chicago school spending per student is up 97% even as test scores have gone down.

But we shouldn’t just pick on Chicago schools.  A recent study that used AI looked at SAT scores since 2008.  Including the effect of the test getting easier, average math scores are down more than 100 points in the past fifteen years with most of the drop since 2019, right before COVID.  Those who want to impose price controls on the private sector want to punish shrinkflationists.  But schools have been charging more and shrinking the education they’re giving our kids.  Where is the plan to fix that?

Ultimately, the best way to fight inflation is to have the Fed focus on price stability while the government minimizes taxes and regulation to encourage competition and risk-taking.  Competition, not new regulations, is the way to keep prices down.  School vouchers would certainly accomplish this for education.   

The key assumption behind price controls is the rationalist delusion that some group of policymakers can figure out what a “fair” price is for each and every good and service across the vast US economy.  It’s the pretense of the kind of central planners who ran the Soviet Union’s economy for decades.  

The good news is that we think price controls are a very long shot to take effect.  Even already, a candidate suggesting price controls is backpedaling, probably realizing that many political allies think it’s a very bad idea.  Meanwhile, it’s unlikely that, outside wartime, such a plan could be imposed without new legislation and that legislation would probably not have the votes to pass.

Brian S. Wesbury – Chief Economist

Robert Stein, CFA – Deputy Chief Economist

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Implications:  July was a tough month for homebuilders, as both housing starts and new permits fell to the slowest pace since the COVID shutdowns.  Moreover, the decline would have been worse but for a 14.5% jump in starts for the volatile multi-family category, which partially cushioned the drop in single-family starts to a sixteen-month low.  The silver lining for future homebuyers is that builders have been focusing their efforts on completing projects already in progress.  Despite a dip in July, completions are up 13.8% in the past year and stand near the highest pace seen since 2007.  With strong completion activity and tepid growth in starts, the total number of homes under construction continues to fall, now down 8.3% since the start of 2024.  That type of decline is usually associated with a housing bust or recession.  The lack of new construction is why home prices have remained elevated while rents are still heading up in much of the country: we are building too few homes while lax enforcement of immigration laws mean rapid population growth.  We think government rules and regulations are likely the major hurdle for builders in much of the country, but home construction might also be facing headwinds from a low unemployment rate (which makes it hard to find workers) as well as relatively high mortgage rates.  The home building sector seems strangely slow given our population growth and the ongoing need to scrap older homes due to disasters or for knockdowns, which is why we think government rules and regulations are likely the central problem.  That said, there are some tailwinds for housing construction, as well.  Many owners of existing homes are hesitant to sell and give up their fixed sub-3% mortgage rates, so many prospective buyers will need new builds.  In addition, Millennials are now the largest living generation in the US and have begun to enter the housing market in force, which represents a demographic tailwind for activity.  Putting it together, we don’t see housing as a major driver of economic growth in the near term, but we’re not expecting a housing bust like the 2000s on the way, either.  As the Fed eventually begins to cut rates, mortgage rates should trend lower as well, helping put a floor under housing later in 2024.

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