There is more than one reason the 10-year Treasury yield is 5.23% today.  Most importantly, the Fed has stopped anchoring interest rates at artificially low levels.   Fear of inflation is likely another.  However, both of those are related to the massive government debt the US has created.

Fiscal Year 2026 ends September 30 and it looks like net interest on the national debt will top $1.0 trillion, which is more than the US spends on its military.  At $ 1.0 trillion, the US will spend 3.3% of GDP on interest, the highest on record going back to at least World War II.  In the 1980s and 1990s, the US had debt payments relative to GDP nearly this high.  Yet, interest rates were falling!

Why?  Because the US had a path to better fiscal health, including President Reagan’s supply-side tax cuts (which boosted GDP growth).  Reagan also boosted defense spending but restrained other spending.  Then Reagan’s policies led to a collapse in the Berlin Wall and the peace dividend that followed.  President Clinton and House Speaker Newt Gingrich brokered deals to reduce spending more (Ending Welfare as We Know It).  These fiscal actions resulted in budget surpluses and net interest expenses falling to a range of 1 – 2% of GDP for 25 years.

This time around, we think the problem is much worse than back in the 1980s-90s and the prospect for bringing interest costs back down to the 1-2% range are much slimmer. 

Social Security and Medicare costs have gone from about 6% of GDP in the 1980s-90s to about 9% now.  And military spending can’t really go much lower.

In other words, although we’d love to see a set of policies put in place to bring the interest burden back down, with our current Congress focused on College Football and not spending restraint it’s hard to imagine it not going even higher.

We think this is part of the reason why long-term Treasury yields are up so much recently.  The saving rate is lower as a share of income than net interest as a share of GDP for the first time since these data were fully measured.  And that makes it tough to fund both $2 trillion budget deficits and $1 trillion in datacenter buildouts at the same time.

The best path for the federal government to take would be to continue the recent downward pressure the Trump Administration has exerted on domestic discretionary spending.  But that’s unlikely to be enough.  Going forward, the US budget position cries out for entitlement reform, but Congress seems unable, unwilling, or unconcerned about acting.

Our biggest fear is that if we wait too long to address entitlements we may eventually get to the point where tax hikes become necessary, or at least very likely, like a national consumption-style tax or value-added tax layered on top of our already overly burdensome set of taxes.  Even Reagan signed some tax hikes into law, but to be fair at the end of his term actual tax rates were significantly lower than when he took office.

We aren’t predicting Armageddon any time soon, but one way or another our debt burden is pushing inexorably toward a breaking point.

Brian S. Wesbury – Chief Economist

Robert Stein, CFA – Deputy Chief Economist

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Implications:  New orders for durable goods took a breather in August, remaining little changed versus July.  The good news is that orders fared slightly better than consensus expectations, with growth elsewhere offsetting a 0.6% decline in the transportation sector.  Transportation is a notoriously volatile category month to month, so we prefer to focus on orders outside the sector for a better check on the broader economy. Orders excluding transportation continue to rise, up 0.3% in August and 11.2% in the past year. The increase in these new orders was led by industrial machinery (+1.1%), primary metals (+1.2%), and electrical equipment (+1.1%). Notably, orders for computers and electronic products were unchanged in August after dropping 0.7% in July, a slowdown for a category that has benefited significantly from the recent surge in capital investment for data centers.  Despite the drop, orders in this category are up 16.5% in the past year – trailing only June for its largest annual gain in about 20 years. The most important number in today’s release is core shipments – a key input for business investment in the calculation of GDP – which climbed 0.6% in August following a 1.4% increase in July. If unchanged in September, core shipments would rise at a 14.5% annualized rate in Q3 versus the Q2 average, an acceleration from the 11.6% pace in Q2.  These shipments are up 11.4% over the past year, the largest annual gain outside the COVID years since 2012, as capital spending from the hyperscalers, the reshoring of production, and a more favorable tax environment for investment have helped drive a strong increase.  Meanwhile, increased defense procurement has provided another boost, with defense shipments rising 28.0% over the past year and nearly doubling since 2019.  As you can see in the nearby charts, the strength we see in the durable goods data today is a far cry from three years ago.

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Estimates suggest that over half of the hardware used in the AI buildout is sourced from overseas, meaning hundreds of billions of U.S. dollars are being sent abroad to fuel this acceleration. In this week’s “Three on Thursday,” we examine the AI investment wave’s impact on international trade data and explore how it is shifting trade dynamics. To learn more, click the link below.

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Implications: New home sales rebounded in August, hitting the fastest pace so far this year. Sales are now at an annual pace of 684,000, right around pre-pandemic levels, which has been a ceiling of sorts for activity the past couple of years.  Unfortunately, ongoing conflicts in the Strait of Hormuz and between Russia and Ukraine are having upward impacts on energy prices and inflation which have introduced new challenges. First, financing costs have risen, with the average 30-yr fixed mortgage rate up roughly 100 basis points since early this year.  Second, the Federal Reserve has begun hiking interest rates again, which will disproportionately impact the already weak housing sector. But while buyers are unlikely to get much help from interest rates, the good news is that prices have been trending lower for new builds in the past several years. Median sales prices are down 14.5% from the peak in October 2022.  Meanwhile, the Census Bureau reports that from Q3 2022 to Q2 2026 (the most recent data available) the median square footage for new single-family homes built rose 2.5%. So, buyers are seeing a drop in the price per square foot, not just smaller/lower cost options.  This is partially the result of developers offering incentives to buyers in order to move inventory. Supply has also put more downward pressure on median prices for new homes than existing homes.  The supply of completed single-family homes has been trending down recently but is still up 260% versus the bottom in 2022. This contrasts with the market for existing homes, which continues to struggle with convincing current homeowners to give up the low fixed-rate mortgages they locked-in during the pandemic to list their homes. While financing costs continue to add uncertainty and keep buyers on the sidelines, less expensive options and an abundance of inventories may give home sales a modest boost through the end of 2026. On the employment front, initial jobless claims fell last week by 1,000 to 197,000; continuing claims rose 2,000 to 1.719 million.  These figures signal continued job growth.  On the manufacturing front, the Richmond Fed index, a measure of mid-Atlantic factory activity, slipped to -2 in September from +4 in August, while the Kansas City Fed Index rose to +14 in September from +10 in August.  Finally, the M2 measure of the money supply grew 0.5% in August and is up 5.7% from a year ago. This remains below the 6% growth trend prior to COVID, when inflation remained low.

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Implications: Industrial production took a breather in August following four consecutive months of growth. The primary driver was weakness in the manufacturing sector, which has been benefitting from AI investment related tailwinds, but posted the first decline of 2026.  Looking at the details, the volatile and tariff-exposed auto sector fell 1.2% in August.  However, manufacturing excluding autos (which we think of as a “core” version of industrial production) declined 0.2% as well. Surprisingly, production in high-tech equipment, which has been a consistent source of strength recently due to data center construction and the reshoring of semiconductor production, slipped 0.1% in August. While that is the first decline in five months, production in this sector is still up 12.5% in the past year, the fastest of any major category. The manufacturing of business equipment also fell 0.5% in August but is up 7.0% in the past year, continuing to outpace the 1.5% gain in overall industrial production and signaling a broader reindustrialization.  Looking outside the manufacturing sector, mining activity eked out a gain of 0.1% in August.  The increase was driven by drilling activity as well as more extraction for other minerals, which more than offset a decline in oil and gas extraction.  Meanwhile, utilities output (which is volatile and largely dependent on weather from month to month) posted a gain of 1.7% in August. Notably, this series has been on an upward trend since 2023, following nearly twenty years of stagnation, as power hungry data centers have boosted demand for US power generation.

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It wasn’t that long ago that Kevin Warsh’s leading critics were saying his biggest problem was that he wasn’t “independent” from President Trump, that if Trump told him to “jump” he’d ask “how high?” Or, in this particular situation, “how low should interest rates go?”

And yet at only his third meeting at the helm, Chairman Warsh didn’t cut rates; he raised them.  In addition, the “dot plot” from the Federal Reserve strongly suggests another rate hike later this year, which we think will arrive in December.

Some may argue that Warsh was “forced” to raise rates because inflation remains a problem.  But higher energy prices since February are the result of the conflict with Iran as well as the Russia-Ukraine War, which have combined to reduce oil flows as well as the production of refined products.  Excluding energy, consumer prices are up 2.5% from a year ago, the smallest increase since the first year of COVID.  So all of the acceleration in inflation versus a year ago is due to energy, and monetary policy has zero chance of clearing blockades in the Middle East or bringing peace to eastern Europe.

In addition, the growth of the M2 measure of the money supply has been slower in the last few years than in the decade prior to COVID when the Fed’s preferred measure of inflation hovered below 2.0%.

In other words, the recent rate hike was not required, and Warsh was not “forced” to raise rates.

Warsh was never going to be the rubber stamp for Trump that his critics claimed, and at least so far, he is more independent than former Chairman Jerome Powell, who has broken long-term norms by keeping his regular member seat on the Fed Board even though his term as chairman has expired.

It was the Powell Fed that twiddled its thumbs and came up with excuses for not acting against inflation in 2021 under President Biden, even as the M2 measure of money exploded and CPI inflation was headed toward 9.0%, making up excuses about the surge in inflation being “transitory.”  It was also Powell that made it easy for the Biden Treasury to borrow trillions by buying Treasury debt and holding rates down.

The biggest surprise for today’s critics was the relative calm with which Trump reacted to the increase in short-term rates.  We think much of this is due to Treasury Secretary Scott Bessent, who we understand recommended that Trump nominate Warsh in the first place, and who appears to have convinced Trump (at least for the time being) that accepting Warsh’s decisions on monetary policy would be best for the country as well as Trump’s political position.

To understand this, you must look back on President Reagan in 1981-82.  He counted on Chairman Volcker to do the right thing for the long term, even if it hurt in the short term.  And Volcker aggressively raised rates even as the country was then experiencing one of the deepest recessions since World War II.  Inflation came down, and the economy took off.

An independent Fed that is insulated from politics will help maximize economic growth.  But if we want an independent Fed that can ignore politics, we need a government that stops interfering with the economy.  

A highly regulated economy is a slower-growing economy.  With slow growth, politicians lean on the Fed to artificially boost growth even if the sugar-high from easy monetary policy is temporary.  And don’t forget, with Powell at the helm, the Fed supported regulations…even on wasteful green energy.

The same goes for when the government spends too much. The Trump Administration has made some progress on spending so far.  Adjusted for inflation, total federal outlays in the past twelve months (September 2025 – August 2026) are down 3.3% from the last twelve months of the Biden Administration (February 2024 – January 2025), a notable achievement given higher interest costs, more military spending, and aging Boomers.

However, spending is still too high and annual interest paid on the national debt as a percent of GDP is greater than the personal saving rate for the first time on record.

It doesn’t matter who leads the Fed in the next few decades: if the government is too big, politicians of both parties are going to try to pressure it to keep interest rates low to make it easier to finance the federal debt.  In addition, it will be even harder to enact growth-enhancing tax cuts that would help the Fed pursue price stability like it did in the 1980s and 1990s.

The bottom line is that Fed independence is not just about the personality of the person who sits in the Oval Office; it’s about the big picture policy environment in which the Fed has to operate.  A smaller government would help us reach that goal.

Brian S. Wesbury – Chief Economist

Robert Stein, CFA – Deputy Chief Economist

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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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