In this week’s “Three on Thursday,” we take a closer look at the current role of tariffs in U.S. economic policy. Now well into his second term, the president has broadened tariff measures across nearly all trading partners, turning customs duties into both a source of federal revenue and a strategic policy tool. To see how this new tariff era is taking shape for the time being, click the link below.

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Implications:  The sector responsible for two-thirds of US output once again demonstrated its strength, as the ISM Services Index beat even the most optimistic forecast of any Economics group polled by Bloomberg and rose to an eight-month high of 52.4 in October.  Despite continued weakness in its counterpart survey on the manufacturing sector, the service sector remains far more resilient, with activity expanding in ten out of the last twelve months.  Looking at the details, the pickup in the headline index came from a swift jump in the new orders index, where growth accelerated to the fastest pace in a year.  Meanwhile, the business activity index rebounded from contraction territory last month (albeit, barely) at 49.9 and rose to 54.3 in October.  Survey comments indicate a fractured growth picture, as some voice concerns about the impacts of additional tariffs and the federal government shutdown, while others indicate business as usual.  Notably, a survey comment from the Retail Trade industry wrote, “Business is very strong, no supply chain or logistical issues.”  Still, this bumpy path has kept service companies defensive in their hiring efforts.  Employment continued to contract in the service sector in October (but at slower pace compared to last month), with the category rising from 47.2 to 48.2.  That makes seven out of the last eight months where the employment index has been below 50, signaling contraction.  Service companies – once hamstrung with difficulty finding labor – have begun reducing their headcounts, with more industries (ten) reporting lower employment in October than higher (four).  Finally, the highest reading of any category was once again the prices index, which ticked up to 70.0 in October.  That is the highest level since late 2022 but still far from the worst we saw during the COVID supply-chain disruptions, when the index reached the low 80s.  Though inflation pressures remain, the M2 measure of the money supply has grown very slowly for three years, which means we are likely to see lower inflation and growth in the year ahead.  As for the economy, it’s important to remember that Purchasing Manager’s surveys like the ISM Services index and its counterpart on the manufacturing sector often capture sentiment mixed in with actual activity.  Uncertainty from trade policy and the lapse in government funding have been weighing on sentiment, but that could fade as more clarity emerges.  However, monetary policy has been tight enough to reduce inflation toward the Federal Reserve’s 2.0% target and is probably still modestly tight today.  And a monetary policy tight enough to reduce inflation may also be tight enough to slow the US service sector.  In other news this morning, ADP reported private payrolls rose 42,000 in October after declining 29,000 in September.

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Implications:  A rare update on the economy showed manufacturing activity slipping further in October, with the ISM Manufacturing index missing consensus expectations and falling to 48.7.  This makes eight consecutive months that the index has been below 50, continuing a pattern that stretched all of 2023 and 2024.  Though many believed the downturn was over when the index briefly rose above 50 in January and February, the subsequent eight months of weak readings indicates the sector continues to struggle for traction.  Looking at the details, just six of the eighteen major manufacturing categories reported growth in October, while double reported contraction.  The overall decline was driven by pullbacks in the production and inventories index, with production falling back into contraction at 48.2 and inventories contracting at the fastest pace this year at 45.8.  Meanwhile, demand remains subdued, with just four major manufacturing industries reporting growth in new orders versus nearly triple (eleven) reporting a decline.  Order books were weak heading into this year, but now, survey comments blame trade uncertainty for the weakness as many customer orders have been placed on pause until stability returns.  This has caused companies to look for ways to reduce overhead, most notably through their hiring efforts.  Though the employment index rose to 46.0, it remains firmly in contraction territory, with only three major manufacturing categories reporting an increase in employment in October versus thirteen reporting a decrease.  The one piece of good news is that inflation pressures continued easing in October, with the prices index declining for the fourth consecutive month.  The 58.0 reading is below the recent peak of 69.8 in April, and well below the levels during the post-COVID inflation surge.  Last Tuesday we learned the M2 measure of the money supply rose 0.5% in September and is up 4.5% from a year ago.  If we compare to the M2 peak during COVID, in April 2022, the money supply is up a total of just 2.1% in the past 41 months.  This slow money growth should help keep inflation on a downward trajectory.  On the housing front, the national Case-Shiller index rose 0.2% in August while the FHFA measure of home prices rose 0.4%, the first monthly increases for either index in at least four months.  Compared to a year ago, FHFA prices are up 2.3% while Case-Shiller prices are up 1.5%, both less than overall inflation. Finally, pending home sales, which are contracts on existing homes, were unchanged in September following a 4.2% jump in August, suggesting existing home sales (counted at closing) will be little changed in September.

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History is absolutely clear – Capitalism is the best system ever developed (actually evolved by human experiment) to boost living standards.  At the same time, Socialism has a seriously lousy record.  In the most recent attempt, Venezuela has gone from one of the wealthiest countries in South America, to one of the poorest.  In spite of the very clear record of capitalism’s success, many want to “bite the invisible hand” that feeds us.  On Tuesday, it appears that New Yorkers – who live arguably at the historic center of American capitalism – will elect an avowed “democratic socialist” as mayor, who wants to use the visible hand of government to direct resources.

It’s not like capitalism hasn’t faced intellectual challenges before.  Historically, they tend to fall into three categories.  First, capitalism leads to excess and then collapse – citing the Great Depression and the Subprime Panic of 2008 as example.  Second, it ignores environmental costs (“externalities”) which may hurt the earth, like “climate change.”  Third, it causes inequality – houses are unaffordable, while billionaires proliferate.

We don’t have the space to deal with each of these in depth.  But it is well documented that the Great Depression was caused by a series of government mistakes, most important lousy Federal Reserve policy, which caused deflation and bank failures.  It wasn’t capitalism’s fault.

Again in 2008 subprime problems were caused by overly loose monetary policy between 2001 and 2006, which boosted riskier mortgages and drove up home prices.  In the meantime, government-sponsored enterprises stoked lending to meet political goals.  Then when the losses appeared, mark-to-market accounting made the multiples worse by forcing banks to price and sell assets in an illiquid market at less than their actual cash-flowing value.

Ending overly restrictive mark-to-market accounting would have fixed the crisis immediately, but instead the Bush Administration supported TARP and Quantitative Easing.  At the time we said that they were the biggest mistakes Republicans had made since Herbert Hoover raised taxes and signed the Smoot-Hawley Tariff Act into law (even though we had been running trade surpluses).  Bailing out banks while foreclosures spread made it appear that capitalism was really about socializing losses and benefiting greedy bankers.

What about externalities?  Just last week, Bill Gates made news when he said the risks from climate change are exaggerated, resources have been misspent, and humanity is not going to be wiped out.  

Which leaves us with the final argument against capitalism – inequality.  This is the basis of Zohran Mamdani’s campaign for Mayor of New York City.  He says billionaires shouldn’t exist and housing is unaffordable, and this has gained traction among many voters, especially younger generations.

What is so frustrating about this argument today is that the policies the US government has followed since 2008 are directly responsible for a surge in inequality.  George Bush the Younger defended TARP by saying he had to violate free market principles to save the free market.  We said at the time that that made no sense.  He was just undermining those principles in the marketplace of ideas.  It gave intellectual carte-blanche to those who openly oppose capitalism to do so more brazenly.

Quantitative easing was a huge mistake (both during the 2008 Panic and COVID).  The US money supply has tripled in just eighteen years.  The result is higher inflation, not just for consumer goods, but for housing and asset prices as well.  What this means is that those with assets (stocks and homes) gained ground; those without assets lost ground.

We can think of no set of economic policies, other than the pure corruption we often see in third-world countries, that has caused more inequality.  In other words, it was not capitalism, but government policy mistakes that caused the recent surge in inequality.  Fixing it with more government interference in the markets will only compound the problems.

None of this can be blamed on one political party or the other.  However, it can be blamed on politicians, who for almost 100 years have invented one new government program and policy after another.  While the US has the characteristics of a capitalist system, government (at all levels) plus the cost of regulation exceeds 50% of GDP.

So, forgive us when we hear capitalism doesn’t work.  That’s not an argument that holds much water anymore.  Unfortunately, the failure of government seems to be leading people to vote for even more of it.  If the country as a whole goes in this direction, debt, deficits, inflation and inequality will all become even bigger problems than they are today.

Brian S. Wesbury – Chief Economist

Robert Stein, CFA – Deputy Chief Economist

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This week’s “Three on Thursday” examines the semiconductor industry and American progress in independent chip manufacturing. Rising political tensions and supply chain issues pulled back the curtain on the entangled industry back in 2020. Two years later, demand surges for AI and data centers put semiconductors even further under the microscope. For insight on where the US is situated, click the link below.

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The Federal Reserve cut rates by a further 0.25% today, despite the ongoing government shutdown meaning limited data releases to judge the pace of progress on the dual mandate.  At the same time, the Fed announced an end to reducing its balance sheet. Markets have been pricing in another rate cut to come in December, but all eyes were on Powell for any hint at how the Fed is leaning. 

Other than the rare cut and end of QT starting December 1, the Fed statement was little changed in substance from the meeting mid-September.  Most text changes were simple wording shifts to note that job gains had slowed and the unemployment rate ticked higher as of the last time employment data were released in early September.  Meanwhile, last week’s CPI release showed inflation still running above the Fed’s 2% target. Notably there were two dissents to today’s actions, and they moved in opposite directions. Fed Governor Stephen Miran voted for a larger 0.5% cut, while Kansas City Fed President Jeffrey Schmidt voted to hold rates steady.

With little forward guidance on Fed thinking in the published statement, focus shifted to today’s press conference for clues on what to expect at the Fed’s final FOMC meeting of the year scheduled for December 9-10. And the press conference did not disappoint.

Even before getting into questions before the press, Chair Powell headed off the two questions that were sure to be asked. First, he began by emphasizing that today’s meetings saw “strongly differing views on how to proceed in December” and that nothing is set in stone about how the FOMC will proceed at the next meeting. Differing views are in part due to varying levels of risk aversion from voting members, while also in part a question of how to proceed without the normally available data to judge progress.  There are some non-governmental data releases – such as the ADP employment data out earlier this month reporting a decline in jobs for September, state level unemployment claims, regional Fed Bank surveys, and the ISM reports – that the Fed can use for guidance, but their preferred measures are out of reach for the foreseeable future. As a result, the Fed is treating the current environment like driving in the fog, you still can still drive forward, but you slow down.           

The second item that Powell addressed was the reasoning behind the end to the QT process.  Put simply, the Fed has been debating when to end QT for some time, and were watching repo rates – amongst other data – for signs of financial market tightening. Recent weeks have seen an uptick in those signals of tightening, and the Fed feels like current Fed balance sheets now look “ample”. At $6.6 trillion, the Fed’s balance sheet is multiples larger than it was before the Fed’s decision to begin quantitative easing back in 2008, shifting the financial system from a scarce reserve system to an abundant reserve system where the Fed paying banks – not the banks bidding based on demand – dictates rates.  We could debate until our faces turn blue the many unintended consequences and policy mistakes associated with QE, but for now the Fed is moving toward a more “neutral” stance with regard to their holdings, and by keeping the balance sheet size constant, it will gradually shrink as a percent of total financial market assets.           

We expect the Fed will cut again at the next meeting, and anticipate further cuts to come in 2026 as inflation moderates and employment remains weak (for more on our inflation outlook, check out this week’s Monday Morning Outlook).  

Much is in motion as we near the end of 2025.  Tax policy, tariffs, and the AI building boom have led businesses to pick up the pace of domestic investment. Regulatory changes and productivity gains could push growth to move even faster in the years ahead. But we are also still dealing with the uncomfortable process of moving away from government stimulus and massive deficit spending that have boosted growth numbers in the post-COVID era but were unsustainable.  Progress is being made, but there is still much work to do. And with the Fed at the wheel, mistakes aren’t out of the question.

Brian S. Wesbury – Chief Economist

Robert Stein, CFA – Deputy Chief Economist

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A small part of the federal government took a short break from being shut to make sure the Labor Department could deliver the September Consumer Price Index.

What made this particular CPI report so special?  Because the Social Security Administration needs this inflation report to calculate and announce the Cost-of-Living-Adjustments (COLAs) for Social Security beneficiaries for 2026.  As a result, this legal requirement magically and temporarily transformed some government statisticians into “essential” workers – who have to report to work during shutdowns – versus “non-essential” workers, who don’t have to report to work.

The report also gave the Federal Reserve and the general public a glimpse at recent inflation trends and there the news was mixed.

Yes, the September CPI was reported slightly below the consensus forecast with overall inflation at 0.3% versus an expectation of 0.4%.  The “core” CPI, which excludes food and energy, rose 0.2% versus an expected 0.3%.  Both overall and core prices are up 3.0% from a year ago, which is above the Fed’s supposed target of 2%.

In fact, since Jerome Powell took the helm at the Fed, consumer price inflation has averaged 3.5% annualized.  But, if we look at just the last 8 months (since January, which would include new tariffs) overall prices are up at an annual rate of 2.5% with core prices up 2.7%.  In September it was energy prices that held the inflation number up, and we get it, every month it seems to be one thing or another.  So, some are arguing that inflation is being stubborn and won’t come down.

But, if we look at the M2 money supply, which has grown 6.4% per year with Powell at the helm of the Fed, in the past twelve months it is up only 4.8%.  If we compare to the M2 peak during COVID, in March 2022, the money supply is up a total of just 2.0% in the past 40 months.  This slowdown in money growth should help keep inflation on a downward trajectory.  No, prices will not return to levels that existed before the surge in inflation during COVID, but the rate of increase in those prices should slow.

One piece of good news in the report was that housing cost increases are cooling off.  Rent growth slowed noticeably in September and was up only 3.5% from a year ago, the smallest twelve month change since 2021.  To put this in perspective, annual rent growth peaked at 8.3% in early 2023.

The reason this is important is because rent makes up about 35% of the overall CPI and other data suggest rents will continue to decelerate.  A quarterly series called the “new tenant rent index” teases out the rent that is paid by new tenants only.  Historically, this new tenant rent index leads the overall shelter part of the CPI by a year, which makes sense given that many apartment or home leases last one year. 

The key is that this index plummeted in the second quarter of 2025, dropping 8.4% in that one quarter alone (for a drop at a 29.6% annual rate – not a typo!), by far the steepest drop for any quarter on record going back the last twenty years.  In other words, the rent portion of the CPI is likely to cool noticeably in the year ahead, which could help quell fears of high inflation and create room for some more modest rate cuts ahead.

And in spite of all the talk from the Fed about trying to preserve its “independence,” we think Chairman Jerome Powell’s legacy – he will almost certainly be replaced by May 2026 – is the subordination of monetary policy in 2020-2021 to “COVID Catastrophism,” resulting in the highest inflation since the early 1980s.  Not only did Powell fund the government’s massive deficits at inappropriately low interest rates, but he also misused cash flow from the Fed’s portfolio of assets to pay for politicized research and activity well beyond the Fed’s statutory mandate.  

The legacy will also include “standing up to” presidents when he thinks it suits him but not when he doesn’t, which means not really standing up to presidents as much as picking and choosing what political causes he wants to champion, like growing the size of the federal government.

The next few years will be critical for whether investors’ expectations of inflation remain anchored or creep up like they did in the late 1960s and throughout the 1970s.  There are reasons for some optimism in the short-run on inflation, but we still remain more concerned about the long-term. 

Brian S. Wesbury – Chief Economist

Robert Stein, CFA – Deputy Chief Economist

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Implications:   The September CPI report was originally scheduled to come out October 15th, but the ongoing government shutdown delayed its release.  While most BLS staff remain on leave, enough were called back to prepare this month’s report (September CPI data collection was completed before the shutdown) so the Social Security Administration could calculate its annual cost-of-living adjustment.  Diving into the details of the report, inflation came in below expectations in September, with the Consumer Price Index increasing 0.3%, and the year-ago comparison climbing to 3.0%.  “Core” prices, which strip out food and energy, also came in below consensus expectations, rising 0.2% versus a consensus expected +0.3%, while the twelve-month core comparison moved down to 3.0%.  Yes, year-ago inflation readings remain elevated because of weak inflation data from twelve months ago dropping off the comparison, but the slow growth in the M2 measure of the money supply suggests that lower inflation and slower growth are on the horizon.  Looking at the details, the volatile energy category led the overall increase, rising 1.5% as gasoline prices jumped 4.1%.  Stripping out energy and it’s often-volatile counterpart, food prices (+0.2% in September), “core” prices rose 0.2%.  Housing rents (those for actual tenants as well as the imputed rental value of owner-occupied homes) have been the main driver of core inflation over the last three years, but that tide is turning: rents rose just 0.1% in September, the smallest monthly increase since 2021.  Instead, it’s been airline prices that have picked up steam in the core category, rising 2.7% in September after large jumps of 5.9% and 4.0% in the two months prior.  Other core categories to increase were prices for apparel (+0.7%) and new vehicles (+0.2%).  Meanwhile, motor vehicle insurance and used car prices both declined 0.4%.  With the labor market showing signs of softening and the federal shutdown ongoing, we believe this report keeps the Federal Reserve on course for another reduction in short-term rates at next week’s meeting.

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The federal government closed out fiscal year 2025 at the end of September, and in this week’s “Three on Thursday,” we dive into the current state of federal finances, offering a historical perspective as well. With annual deficits now in the trillions and interest payments on government debt at record levels, it’s clear that significant changes are needed. For further insight, click the link below.

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Implications:  Existing home sales posted a modest gain in September, though activity continues to trudge along at a disappointing pace. The current pace of 4.060 million remains near the lowest since the aftermath of the Great Financial Crisis, and well below the roughly 5.250 million annual pace that existed pre-COVID (let alone the 6.500 million pace during COVID).  That said, affordability has been improving in several notable ways. First, 30-year mortgage rates have been trending lower since May and now sit around 6.3%.  Notably, this is the lowest rate since 2023 and with the Federal Reserve restarting rate cuts recently, buyers have reason for further optimism. Meanwhile, the median price of an existing home is up just 2.1% versus a year ago. It looks like the inventory of existing homes rising 14.0% in the past year has helped put a lid on prices as more options become available for buyers.  That has helped push up the months’ supply of homes (how long it would take to sell existing inventory at the current very slow sales pace) to 4.6 in September, a considerable improvement versus the past few years, and approaching the benchmark of 5.0 that the National Association of Realtors uses to denote a normal market. One last positive to note is that aggregate wage growth (hourly earnings plus hours worked) has begun to consistently outpace median home price gains over the past year for the first time since 2023, which improves affordability. That said, some challenges remain. 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 an impediment to activity by limiting future existing sales (and inventories).  Existing home sales also face significant competition from new homes, where in many cases developers are buying down mortgage rates to compete and move inventory (when interest rates are higher, firms, including homebuilders, forego more potential earnings by holding onto inventories). Despite these cross currents, underlying fundamentals have improved recently, which should contribute to a modest rebound in sales. In other recent housing news, the NAHB Index (a measure of homebuilder sentiment) rose unexpectedly to 37 in October from 32 in September.  Keep in mind a reading below 50 signals a greater number of builders view conditions as poor versus good, now the eighteenth consecutive month that has been the case. On the manufacturing front, the Empire State Index – a measure of factory sentiment in the New York region – rebounded sharply to +10.7 in October from -8.7 in September. Meanwhile, its counterpart the Philadelphia Fed Index fell to -22.2 in October from -12.3 in September.

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