Since 2008, the Federal Reserve (the “Fed”) has operated under an “abundant reserves” framework — a significant departure from its prior operating approach. While the Fed believes this framework has helped support financial markets and economic activity, it has also produced notable side effects. Last week, the Fed released its Q2 quarterly financial report, detailing the combined financial position of the 12 Federal Reserve Banks. Click the link below to find out more.

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Implications: Service sector expansion picked up steam in August, with the ISM Services Index rising to 55.4 from 54.1 in July.  Faster growth in business activity and new orders outweighed continued price pressure and soft hiring. Despite the conflict in the Middle East (including the downstream effect on energy prices) and the often-changing tariff landscape, service activity has expanded on the faster-end of post-pandemic levels in 2026, with the services index reading above 53.0 for nine consecutive months, the longest stretch since 2022.  Looking at the details, overall growth was broad in August, with twelve out of the eighteen major service industries reporting expansion, while five reported contraction, and one reported no change. The major measures of activity were mostly higher in August. The business activity index rose to 61.7 from 59.1, boosted in part by positive summer seasonality, and reaching the fastest pace since late 2022.  The new orders index also improved, registering 60.9 and reaching a three-year high.  Both forward-looking indices have shown expansion in each of the last twelve months. As caution surrounding supply-chain issues drag on, confidence in the near-term economic outlook remains soft. As a result, service sector hiring weakened once again, with the employment index remaining in contraction territory at 47.8. The services industry has struggled to consistently hire for about three years as the employment index has rarely registered above 50.0 (which would signal expansion) since 2023. Unfortunately, the highest reading of any index was once again the prices index, which rose to 72.6 in August, now the fifth time in the last six months the index has breached 70.0. Though the index remains elevated, it is well below the worst we saw during the COVID supply-chain disruptions, when the index reached the low 80s. While the ongoing conflict in Iran is expected to affect input prices in the short-term, we will continue to monitor the M2 money supply for signals of sustained movements in overall inflation. The money supply is up 5.4% in the past year versus the 6.0% trend prior to COVID when inflation remained low, suggesting that once the conflict in the Middle East is resolved, inflation may drop faster than most investors expect.  In other recent news, cars and light trucks were sold at a 16.8 million annual rate in August, up 2.6% from July, and up 4.3% from a year ago.

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Implications: The trade deficit widened substantially to $88.6 billion in July, the largest since the peak of tariff front-running in March 2025. The shift marks a break from the pattern of the past year, when the deficit held around $50 billion to $70 billion, albeit with considerable volatility.  The break is due to both a $6.6 billion decline in exports and a $10.8 billion rise in imports. Fortunately, a good chunk of the decline in exports came from nonmonetary gold – a category not included in GDP calculations – which should soften a little the impact to net exports on Q3 GDP.  The rise in imports once again reflects the surge in capital spending on computer processing – imports of computers and computer accessories alone rose $13.5 billion in July.  Year to date, these imports are up $164 billion compared to the same period in 2025. Adding semiconductors and telecommunications equipment brings the total increase to $228 billion. This dynamic caused imports of capital goods (which exclude autos) to rise 11.4% in July, the largest monthly gain in the category since 1993. We like to focus on total volume of trade, exports plus imports, as it shows the extent of business and consumer interaction across the border. That measure rose $4.2 billion in July and is up 10.4% in the past year. Over the past year, exports have risen 9.3% and imports are up 11.2%. Meanwhile, the landscape of global trade continues to evolve.  China, once the dominant exporter to the U.S., has slipped to a fourth place behind Mexico, Canada, and now Taiwan, with exports to the U.S. down 19.4% year to date compared to the same period last year. Accelerated demand for high tech equipment stands out in the data with imports from Taiwan up 60.0% over the same period moving them to third place.  Also in today’s report, the dollar value of U.S. petroleum exports once again exceeded imports, marking the 53rd consecutive month of America being a net exporter of petroleum products.  Keep in mind petroleum products include refined products like gasoline, diesel, and propane – all of which the U.S. exports in large volumes. When looking at crude oil alone however, the U.S. remains a net importer (although not nearly as much as in prior decades), largely due to domestic refinement capabilities.  In other recent news, initial jobless claims rose 2,000 last week to 206,000, while continuing claims rose 8,000 to 1.779 million. These figures suggest continued moderate payroll growth.

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Implications: Activity in the manufacturing sector continued expanding in August, although at a slightly slower pace than the previous month.  Despite the headline drop, the 54.6 reading for the ISM Manufacturing index marked the second-fastest pace since 2022.  That is now the eighth consecutive month of expansion, an encouraging development for an industry that has faced significant challenges in recent years.  While we remain cautious for the broader economy, it's clear that AI-related capital investment, the reshoring of production, and increased defense procurement are providing meaningful support to the sector.  Looking at the details of the report, fifteen out of the eighteen major manufacturing industries reported growth in August, with only two industries reporting contraction (Wood and Chemical Products), and one reporting no change. The major measures of activity moved mostly lower for the month, but all stand above 50, signaling growth. It is important to remember that until this year, new orders had been very weak going back to 2023, leaving manufacturers focused on order backlogs to keep production going.  So it’s good to see that along with the rise in new orders (currently sitting at 53.7), order backlogs have grown each month in 2026 after more than three straight years in contraction, currently sitting at 51.8.  The best news in the report is that the recent improvement in demand has finally enticed manufacturers to boost their hiring efforts, with the employment index staying in expansion territory for the second month in a row at 51.2 after nearly three straight years of contraction. Despite the employment index growing slightly slower than the 52.8 reading last month, the mix has improved, with more than double the industries reporting employment growth (seven) versus contraction (three), suggesting the rebound in hiring is extending beyond the strongest areas of the manufacturing sector. On the inflation front, the prices index looks to have stabilized, remaining unchanged from the previous month at 71.1. That is still significantly higher than the 59.0 level at the beginning of the year, but well below its recent peak of 84.6 back in April.  While we still believe there are problems elsewhere in the economy, certain industries are driving a manufacturing rebound that few expected just a year ago.  In other news this morning, construction spending declined 0.5% in July, as a large drop in homebuilding offset a rise in office construction. On the employment front, initial jobless claims fell two weeks ago by 4,000 to 203,000; continuing claims fell 8,000 to 1.778 million.

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Federal Reserve Chairman Kevin Warsh used his Jackson Hole speech last week to lay out what he thinks of monetary policy. Two things jumped off the pages of his speech.

First, “Fedspeak” may be making a comeback. Former Fed Chairman Alan Greenspan became famous for phrases like “irrational exuberance.”  One section of Warsh’s speech, titled “Preparing for Future Policy Conjunctures,” felt like a throwback. “Conjunctures,” really?  Greenspan would be proud.

Second, the narrative about Warsh is that he will get rid of forward guidance and make the Fed more circumspect.  Many thought that would give them less to talk about.  But compared to Jerome Powell, Warsh is much more focused on the monetary side of monetary policy.  Powell wouldn’t answer questions about abundant reserves or money supply.  His press conferences became all about interest rates and tariffs, while Warsh talks about commodity prices and M2.  

Warsh laid out seven principles.  The fifth of which was that “short-term interest rates are the predominant tool” for achieving the Federal Reserve’s mandate.

We completely disagree. If interest rates are the predominant tool, then why did inflation remain stable when Bernanke held rates near zero for seven years, but Powell got 9% inflation after just two years of zero rates? And why has inflation remained stubbornly high even after the rate hikes of recent years?

Interest rates used to signal monetary policy under the “scarce reserve” regime prior to 2008.  Banks traded federal funds, and changes in the supply of reserves helped move short-term rates. Today, banks are flooded with reserves and no longer trade them.  The federal funds rate is rate fixing by the Fed, with little market input. Money and rates are no longer connected. 

That is why Warsh’s sixth principle was so encouraging: “money matters.”  What a breath of fresh air for us Friedmanites who think this was the mistake Powell made, ignoring the 40%+ surge in M2 during the pandemic, causing the highest inflation in 40 years.

There is an interesting tension between his fifth and sixth principles. If money matters, why should short-term interest rates be viewed as the predominant tool of monetary policy? We would reverse the emphasis. Policy should be judged first and foremost by what is happening to the quantity of money, rather than simply where policymakers set an overnight rate. The Fed’s balance sheet, bank reserves, credit creation, and the Treasury General Account matter as well, particularly to the extent they influence the money supply.

Warsh also bashed “forward guidance.”  Forward guidance moves markets.  The Fed says, “this is what we are going to do with rates” and the market moves there.  Then analysts say, “the markets think the Fed should do this, or that.”  But the markets are just responding to the forward guidance.  Warsh calls this a “hall of mirrors” with the markets reflecting the Fed, and then the Fed reflecting the markets.  He is absolutely right.

However, if Warsh really does think that interest rates are the predominant tool of monetary policy, then forward guidance is part of that process.  So, we think he is being a little inconsistent.  Hopefully, he knows this and is just moving the Fed slowly but surely back to a money-focused institution.

He also said the Fed should take responsibility for 65 months of elevated inflation.  It took the Fed nearly 30 years to admit it caused the inflation of the 1970s.  To admit it in just 65 months is a miracle.  What a breath of fresh air in DC.

Finally, his comments leaned hawkish on rates. Markets price a 65% chance of a September hike. We agree and expect that probability to rise. We welcome this new Fed leadership, and a return to more transparent monetary policy.

Brian S. Wesbury – Chief Economist

Robert Stein, CFA – Deputy Chief Economist

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In this week’s “Three on Thursday,” we examine the current state of U.S. household indebtedness and financial health. Curious about the latest trends? Click the link below to get a clearer picture of where things stood in the second quarter of 2026.

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Implications:  New orders for durable goods surprised to the upside in July, rising 1.1% versus the consensus expected 0.5%. The surprise comes in the midst of a resurgence in capital investment for data centers, which has been a tailwind for economic growth this year. That said, the July headline was boosted by a 2.3% rise in transportation equipment, particularly a 12.7% rise in commercial aircraft orders. Transportation is a notoriously volatile category month to month, so we prefer to focus on orders excluding transportation for a better check on the broader economy. Orders excluding transportation continue to rise at a solid pace, up 0.4% in July and 11.0% in the past year, just shy of June’s 11.5% year-ago comparison gain, which was the largest in more than four years. The increase in these new orders was led by primary metals (+1.5%), industrial machinery (+1.2%), and fabricated metals products (+0.4%). Orders for computers and electronic products declined in July (-1.1%) but are still up 14.8% in the past year – close to the largest annual gain in about 20 years. In fact, electrical equipment is the only major category outside transportation to fall short of double-digit growth over the past year, though it’s still up a healthy 6.8% year-over-year.  Arguably the most important number in today’s release is core shipments – a key input for business investment in the calculation of GDP – which rose 1.4% in July. If unchanged in August and September, core shipments would rise at a 12.6% annualized rate in Q3 versus the Q2 average. Business investment has shown strength recently as core shipments have consistently risen for the past year, driven by a more favorable tax environment and the data center buildout. The massive capital spending from the hyperscalers – projected to reach almost $700 billion this year – has been a tailwind for GDP for the past two quarters and should continue to prop up growth if these companies can sustain the spending pace.

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Implications:  Consumers started the second half of 2026 on healthy footing, with income rising 0.4% in July and spending up 0.2%.  Starting with income, growth was led by private sector wages and salaries which rose 0.3% (up 3.8% in the past year) and government transfer payments which were up 0.6% in July (+5.1% from a year ago).  While the 3.8% increase in private sector wages over the past year sounds decent on paper, remember that inflation is up 3.7% over the same period, meaning consumers’ purchasing power is virtually unchanged.  On the spending side, personal consumption rose 0.2% in July, led by financial services and health care, which were partially offset by a decline in spending on gasoline.  Collectively, goods spending (which includes energy costs) fell 0.7% in July, while spending on services increased 0.6%.  The personal saving rate — which tracks how much after-tax income is not consumed — rose to 3.0% in July but remains near the lowest readings since the COVID-era in 2022 (and before that during the Great Financial Crisis in 2008!).  This low level of saving allows for more spending today but isn’t sustainable long-term.  The area of today’s report that will get the most attention from the Fed is the latest reading on inflation. PCE prices – the Fed’s preferred inflation metric – rose 0.2% in July, while the year-ago reading remained at 3.7%.  “Core” prices, which strip out the volatile food and energy categories, also rose 0.2% in July, with the year-ago comparison now at 3.3%, a notable uptick from the 2.9% pace for the twelve-months ending in July 2025.  The Fed will be watching the data closely while trying to determine how monetary policy – which operates with a lag – should respond as inflation remains stubbornly above their 2.0% inflation target.  We wish the Fed would pay more attention to the M2 measure of the money supply, which rose 0.4% in July and is up 5.4% from a year ago.  That is still below the historical growth rate of about 6%, but worth watching closely in the months ahead for signs of any acceleration.  Recent discussion around the Treasury potentially using funds from the Treasury General Account (TGA) to support bond market liquidity for long duration treasuries could lead to a pickup in M2 growth if implemented.  As things currently stand, we expect the Fed will remain on pause for the foreseeable future as they wait for the fog to clear and a better picture of sustained inflation pressures to come into view.  

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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 posted the largest increase in five years with a 9.1% jump in the second quarter and are now up 22.8% from a year ago. The Federal Reserve, after posting massive losses for three consecutive years, finally returned to profitability at the end of 2025 and eked out its third consecutive profit in Q2. Excluding the Fed, corporate profits were up 8.4% in Q2 and 20.6% from a year ago – the fastest growth for any four-quarter period since late 2021.  The increase in Q2 was led by a 10.4% jump in profits earned from domestic non-financial industries, boosted by strong earnings in the technology and energy sectors. Profits from domestic financial companies increased 8.0%, while profits from the rest of the world rose 3.5%.  Despite the rapid growth in Q2, plugging these profits into our Capitalized Profits Model suggests stocks remain overvalued.  In addition, the SpaceX IPO and tariff refunds may have boosted profits artificially. Now back to GDP and the rest of this morning’s report.  Real GDP for the second quarter was unrevised at a 1.5% annualized rate, but reflected a slightly better mix, as upward revisions to personal consumption and business investment were offset by small downward revisions to net exports, inventories, and government purchases. For a clearer picture of underlying growth, we focus on “core” GDP – consumer spending, business fixed investment, and residential construction – excluding more volatile components like inventories, government outlays, and trade. Core GDP was revised higher to a 4.2% annual rate from an initial 3.9%, the fastest pace since early 2023, and is now up 2.7% from a year ago.  So why did headline GDP grow much slower than Core GDP?  Primarily because trade continues to move in volatile swings, shaving off 1.1 percentage points from the headline in Q2.  The most worrisome part of the report was that inflation remains far from the Fed’s 2.0% target, with GDP prices rising at an upwardly revised 6.4% rate in Q2 and are now up 4.4% from a year ago. Nominal GDP rose at an 8.0% rate in the second quarter and is up 6.6% versus a year ago, both figures well higher than the current 3.625% target on short-term rates. That said, much of the inflation pick-up in the second quarter can be traced to the surge in energy prices following the war in Iran and temporary closure of the Strait of Hormuz, and we expect the Federal Reserve to remain on pause as they wait for a better picture of sustained inflation pressures to come into view.

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Implications: New homes sales were softer than expected in July, posting the weakest reading since the start of 2026. Sales are now at an annual pace of 607,000, coming in at the lower end of pre-pandemic levels, which has been a ceiling of sorts for activity the past couple of years.  Unfortunately, the ongoing conflict with Iran and its impact on energy prices and inflation have introduced new challenges. First, financing costs have risen, with the average 30-yr fixed mortgage rate up roughly 60 basis points since the start of the conflict.  Second, despite a new Chairman at the Federal Reserve, further rate cuts are on hold for the time being. 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 14.4% 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 280% 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 in the second half of 2026. In other housing news this morning, the FHFA index remained unchanged in June but is up 2.3% in the past year, while the national Case-Shiller index increased 0.1% in June and is up 1.5% in the past year. On the employment front, initial jobless claims fell last week by 6,000 to 206,000; continuing claims rose 18,000 to 1.799 million.  These figures signal continued job growth.  Finally, on the manufacturing front, the Richmond Fed index, a measure of mid-Atlantic factory activity, slipped to +4 in August from +5 in July.

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