Implications:  The resiliency of the sector responsible for the lion’s share of US output was on display once again in November, as the ISM Services index beat consensus expectations and rose to a nine-month high of 52.6.  Despite continued weakness in its counterpart survey on manufacturing, the service sector has expanded in ten out of the last twelve months.  The modest uptick in the headline index was largely driven by the supplier deliveries component, which surged to a thirteen-month high of 54.1 (a reading above 50 signals longer wait times), likely the result of air traffic disruptions stemming from the government shutdown according to the report.  Partially offsetting this gain was a pullback in the new orders index which remains in expansion territory at 52.6.  Survey comments indicate a fractured growth picture, as some voice concerns about the impacts of additional tariffs and another potential government shutdown in January, while others indicate business as usual.  Notably, a survey comment from the Retail Trade industry wrote, “Business continues to be strong, driven by customer traffic. Pricing stable.”  Still, this bumpy path has kept service companies defensive in their hiring efforts.  The employment index continued to signal contraction in the service sector in November (but at slower pace compared to last month), with the category rising from 48.2 to 48.9.  That makes eight out of the last nine months where the employment index has been below 50.  Service companies – once hamstrung with difficulty finding labor – have begun reducing their headcounts, with more industries (eight) reporting lower employment in November than higher (six).  Finally, the highest reading of any category was once again the prices index, which fell to a seven-month low of 65.4.  Though the index remains elevated, it is still far from the worst we saw during the COVID supply-chain disruptions, when the index reached the low 80s.  While inflation pressures remain, the M2 measure of the money supply has grown very slowly over the past three years.  Last week's data showed M2 rose 0.4% in October and 4.7% over twelve months – below the historical growth rate of ~6% – suggesting lower inflation and growth in the year ahead.  In other news this morning, ADP reported private payrolls declined 32,000 in November, which should translate into a tepid official Labor Department report for job growth last month.

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Implications:  We finally got a look at industrial production for September now that the shutdown at federal government data agencies has ended, and the details were ugly. While industrial production eked out a small gain of 0.1% and manufacturing was unchanged in September, when including big downward revisions to prior months the September numbers were -2.4% and -3.2% respectively.  To put that in context, all growth in both series since the aftermath of the COVID pandemic in 2022 was essentially revised away.  Turning our focus to September itself showed a more mixed picture. The volatile auto sector posted a decline of 2.3% in September.  However, manufacturing ex-autos (which we think of as a “core” version of industrial production) posted a gain of 0.1%, leaving overall manufacturing unchanged.  Meanwhile the typical bright spots in the “core” measure were present as well.  Production in high-tech equipment, which has been a reliable tailwind recently due to investment in AI as well as the reshoring of semiconductor production, posted a gain of 0.6%.  High-tech manufacturing is up 10.8% in the past year, the fastest pace of any major category.  The manufacturing of business equipment also rose 0.7% in September.  This category is up a strong 9.1% in the past year, signaling reindustrialization in the US outside of just the high-tech industries mentioned above.  Looking outside of manufacturing, utilities output (which is volatile and largely dependent on weather) was also a source of strength, with activity rising 1.1%.  Finally, the mining sector was unchanged in September. A faster pace of oil and gas production as well as the drilling of new wells was offset by less extraction of other metals and minerals. Look for the recent upward trend in activity in this sector to continue as the Trump Administration takes a more aggressive stance with permitting.  Lastly, on the trade front, import and export prices were both unchanged in September.  In the past year, import prices are up 0.3% while export prices have risen 3.8%.

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Implications:  Manufacturing activity weakened again in November, as the ISM Manufacturing index missed consensus expectations and declined to a four-month low of 48.2.  This makes nine consecutive months 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 streak of contractionary readings indicates the sector continues to face headwinds.  Looking at the details, just four of the eighteen major manufacturing categories reported growth in October, while nearly triple (eleven) reported contraction.  The overall decline was driven by weakening demand, softer employment conditions, and faster supplier deliveries.  The new orders index – which returned to expansion territory briefly back in August – continues to struggle for traction, as the index fell to a four-month low of 47.4.  Order books were already weak heading into this year, and 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.  The employment index fell deeper into contraction at 44.0, with only two major manufacturing categories (Computer & Electronic Products and Machinery) reporting an increase in employment in November versus twelve reporting a decline.  One component that weighed on the headline index – but is not necessarily negative – was a sharp drop in the supplier deliveries index, from 54.2 to 49.3. Faster deliveries typically signal fewer supply chain bottlenecks, even though they mechanically reduce the headline reading.  Meanwhile, it appears that inflation pressures have begun to stabilize, with the price index ticking up to 58.5 from 58.0 after declining for four consecutive months.  The 58.5 reading is below the recent peak of 69.8 in April, and well below the levels during the post-COVID inflation surge.  Given the slow growth in the M2 measure of the money supply over the last 3+ years, we expect inflation to trend lower in the coming year. 

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In the ten years prior to the onset of COVID, the consumer prices index rose at an average annual rate of 1.7%. Since the onset of COVID the overall CPI has risen at a 4.2% annual rate. Inflation peaked at about 9.0% back in 2022 but is still hovering between 2.5 and 3.0%, which is above the Federal Reserve’s official target of 2.0%.

There are reasons to believe inflation may decline in the year ahead. These include slower growth in the M2 measure of the money supply. While most ignore it, M2 surged 2020-21 signaling the high inflation to come. Since April 2022, it has only grown 2%, signaling the moderation of inflation that the US has seen.

Inflation pushed home prices higher, but the rate of increase has slowed sharply. This could possibly be related to the strict enforcement of immigration laws. Some focus on the fact that fewer workers in construction trades could push up labor costs but forget that it also reduces demand for the existing stock of rental units.

However, there are also some reasons to be concerned about inflation over the medium-term and beyond. It appears that the political consensus in favor of keeping inflation low has eroded. Some economists believe targeting a higher inflation rate (either explicitly or quietly) would give more room for potential growth to expand, while others look back on the pre-COVID trend as risky. With low inflation, interest rates are also lower, meaning the Fed has less room to cut rates in an economic emergency.

If inflation and rates were generally higher, they would have more room to cut rates in another crisis. Perhaps this is why the Fed is considering relaxing capital rules on banks that could free them to lend more aggressively, which would boost the money supply. We have long said that “abundant reserves” are like storing gasoline near your water heater. Cutting capital and liquidity ratios would release some of those reserves.

And this brings us to the most dangerous reason to support inflation. Some think with the national debt at $38 trillion, higher inflation would reduce the real value of that debt and make it easier to pay off with inflated dollars.

But we think policymakers would be making a big mistake if they don’t wrestle inflation back down and keep it there. Higher interest rates increase the cost of capital, while inflation erodes growth. The Reagan boom happened, in part, because Paul Volcker ran a tight monetary ship which brought inflation down after the high-inflation, and slow growth, 1970s.

Moreover, even though the national debt is officially $38 trillion, the unfunded liabilities in Social Security and Medicare – the present value of benefit promises to future retirees over and above the expected revenue in these programs – are roughly $76 trillion. And this form of debt is inflation indexed, in the sense that Social Security benefits are directly indexed to inflation and Medicare spending rises if overall inflation is higher.

So even if higher inflation can temporarily surprise Treasury bondholders, diluting their bonds’ value, as shorter-term debt is rolled over, the US will have to pay higher rates on new debt, while not fixing the long-term entitlement problem.

Here's a better idea and one that has proven successful in the past: have the Fed focused on price stability while Congress and the President take measures (together or separately) to get our fiscal house in order. On the latter front, there are some tentative green shoots. In the past twelve months the federal deficit has been $1.8 trillion versus $2.0 trillion in the twelve months ending in October 2024.

That’s why the next few months of budget battles are important. Will we continue to make (gradual) progress against the deficit? Let’s hope so. In the meantime, President Trump is contemplating who he will pick as the next Fed chief. If the next leader is willing to risk higher long-term inflation to try to use monetary policy to fix our long-term fiscal issues, that would be a negative sign.

The US is at a serious inflection point. While many seem to think inflation can help fix it, we don’t see how.

Brian S. Wesbury – Chief Economist

Robert Stein, CFA – Deputy Chief Economist

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Implications:  Durable goods orders ended the third quarter on a strong note, rising 0.5% in September, with nearly every major category showing gains.  Yes, orders for defense aircraft soared 30.9% for the month, but orders excluding transportation rose a very healthy 0.6% on the month and every major category increased.  The rise in non-transportation orders in September was led by electrical equipment (+1.5%), primary metals (+1.4%), and fabricated metal products (+0.5%), while computers & electronic products (+0.5%) and machinery (+0.1%) also increased.  The most important number in today’s release, core shipments – a key input for business investment in the calculation of GDP – rose 0.9% in September, the largest monthly increase since January of 2023.  For the third quarter as a whole, they were up at a 5.0% annualized rate versus the Q2 average, the strongest quarterly growth since mid-2022.  While employment and inflation remain under the spotlight as the Federal Reserve looks very likely to continue the rate cut process at the next meeting in December, we will also be paying close attention to how businesses – and consumers – continue to respond to the certainty now in place from the passage of the tax bill earlier this year, which should enhance the competitiveness of US companies.  In other recent news, the Richmond Fed Index – a measure of factory sentiment in that region - fell to -15.0 in November from -4.0 in October, while the Chicago Purchasing Managers Index (PMI) – where readings above 50 signal growth – declined to 36.3 in November from 43.8 in October, signaling activity in that region continues to contract. On the housing front, pending home sales (which are contracts on existing homes) jumped 1.9% in October following a 0.1% rise in September, suggesting existing home sales (counted at closing) will modestly rise in November.  Finally, initial jobless claims declined 4,000 last week to 216,000; continuing claims rose 7,000 to 1.960 million. Pairing these figures with other data on employment suggests modest continued job growth in November. 

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Implications:  Growth in retail sales lost some momentum in September, capping off what had otherwise been a solid quarter of spending for US consumers.  Looking at the headline, overall sales rose 0.2% in September – the fourth consecutive monthly increase – but lagged the consensus expected gain of 0.4%.  Sales rose in eight out of the thirteen major categories for the month, led by a 2.0% jump at gasoline stations.  The biggest drag came from nonstore retailers (think internet and mail-order), where sales declined 0.7% in September after a strong 1.6% increase in August. Combined with declines at clothing stores (-0.7%) and sporting goods retailers (-2.5%), the pullback likely reflects a return to more typical spending levels after back-to-school shopping boosted the prior month.  “Core” sales, which exclude volatile categories such as autos, building materials, and gas stations, increased by 0.1% in September but were revised slightly downward for previous months.  The core number is crucial for estimating GDP, because when it calculates GDP the government uses other sources for autos, building materials, and gas, not the retail report.  Despite the weakness in September, these sales were up at a 6.3% annual rate in Q3 compared to the Q2 average, the fastest quarterly pace since 2023.  In turn, it looks like Real GDP grew at a nearly 3.5% annualized pace in the third quarter.  Keep in mind, however, that a monetary policy tight enough to bring inflation down is also tight enough to bring economic growth down.  One category we will be watching closely for this is at restaurants & bars – the only glimpse we get at services in the report, which make up the bulk of consumer spending.  That category rose a solid 0.7% in September following a 1.0% jump in August.  Through the first nine months of the year, these sales are up at a 7.7% annualized rate, above the 2.9% annualized increase for overall sales.  While this report appears out of step with some other signs of a slowing economy, we remain cautious given the potential delayed effects of tighter monetary policy.

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Implications:  Producer prices rose 0.3% in September, matching consensus expectations, and the underlying details continue to show a large degree of volatility.  Among the typically volatile food and energy categories, energy prices jumped 3.5% in September – the largest one-month increase in two years – while food prices rose 1.1%.  Excluding these categories, “core” producer prices rose a much more modest 0.1% in September and are up 2.6% versus a year ago, the smallest twelve-month increase in more than a year.  While the Federal Reserve has a few more data points to be delivered before the next FOMC meeting on December 9th-10th, we expect they will cut for a third consecutive meeting.  The Fed remains concerned that tariffs will push prices higher at some point, but the data have not fully cooperated.  In the past six months, goods prices – which are most exposed to higher import costs – are up at a notable 4.4% annual rate, but that rise has been largely offset by a moderation in services prices, up at a 1.5% rate over the same time period.  Taken together, producer prices are up at a 2.3% annual rate over the past six months, not far above the 2% inflation target.  As we noted in prior reports, tariffs can raise prices for tariffed items, but they leave less money for consumers left over for other goods and services. They shuffle the deckchairs on the inflation ship, not how high or low the ship sits in the water.  That’s up to the money supply, which is up only 2.1% since April 2022.  While volatility may continue month-to-month, we believe monetary tightness will keep inflation relatively subdued and that there is room for modest rate cuts to continue into 2026.  In other news this morning on the housing front, the national Case-Shiller index rose 0.2% in September while the FHFA measure of home prices was unchanged.  Compared to a year ago, Case-Shiller home prices are up 1.3% while FHFA prices are up 1.7%.  While strict immigration enforcement may raise construction costs, by making more older rentals available at lower cost it puts downward pressure on prices for the existing stock of homes.

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Many of you may have recently seen a chart circulating on the internet suggesting a nationwide collapse in home prices is on the way, that we are in the “biggest bubble in history,” the collapse is “inevitable and nothing can stop it.”  The claim is that since home prices adjusted for general price inflation are even higher than they were in the previous bubble that peaked nearly twenty years ago, the coming crash “will be even worse.”

Just to refresh our recollections, the bursting of the last bubble led to a massive decline in home prices, with the national Case-Shiller home price index down 27% in the five years ending in early 2012.  An even larger decline today could be devasting for the US economy.

But we don’t think this is going to happen.

First, it’s important to recognize that one of the reasons housing is so unaffordable is that we have a set of government policies that boost home prices while reducing after-tax incomes.  These include state and local regulations that stifle home construction, government-sponsored enterprises that artificially boost mortgage lending while not boosting housing supply, and a fiscal spending and tax system that leaves potential homeowners with less ability to accumulate a down-payment or meet monthly income requirements.  When government at all levels spends more than 35% of GDP and the overall cost of government – including regulations, for example – is roughly 50% of GDP, there is less left over for what workers actually want versus what the government wants us to have.

Second, the same analyst now making apocalyptic warnings about the housing market did so in June 2019, since which home prices are up 57% overall or 7.6% per year, while the overall consumer price index was up 3.9% per year.

Third, there is a key difference between the bubble twenty years ago and the current environment.  We had massive over-building in the prior bubble, with housing starts averaging 1.9 million per year in 2002-06, versus an average of 1.5 million in the past five years.

To see the importance of housing supply, imagine a hypothetical world in which the government decided to ban all new housing construction.  What would we expect to happen to home prices relative to the general consumer price index?  Obviously, home prices would go way up due to limited supply.  Home prices would also be higher relative to wages.

Clearly, this would be bad policy; we would never want the government to ban home building.  But if it did so the rise in home prices relative to overall prices and wages would not be a “bubble,” it’s what the remaining market forces would require: higher home prices to reflect housing scarcity unless and until the government ended the idiotic ban on home building.  

In a way, that’s what has happened, but not as extreme.  Government has limited homebuilding through environmental rules, zoning, and “affordability” concerns (the latter of which end up making home less affordable!).  And so homes are scarcer than they should be and home prices have gone up relative to the price of other goods and services.  In addition, with so much land unavailable for development, a larger population means higher prices, as well.   

One issue to take note of in the housing market is that strict immigration enforcement so far this year is probably putting modest downward pressure on prices. Case-Shiller home prices were down 0.7% in August versus January.  Yes, strict enforcement should lift the cost of building new homes as the labor supply gets tighter.  But it also makes more rental units available for natives and legal immigrants, which should put downward pressure on rents and let potential home buyers wait longer before they buy.  In turn, that means downward pressure on the price of existing homes. 

None of this is to say all is well with the US economy.  The stock market looks priced for perfection and is underestimating recession risk.  But a housing collapse is highly unlikely and a collapse even greater than the last one even more so.

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 rapid growth of U.S. natural gas exports. Natural gas has become a cornerstone of America’s energy landscape—reliable, flexible, and far cleaner than coal or oil, emitting up to 50% less CO₂ when used for electricity generation. For further insight, click the link below.

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Implications:  Existing home sales posted a modest gain in October to hit an eight-month high, though activity continues to trudge along at a disappointing pace. The current rate of 4.100 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%, near the lowest rate since 2023. 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 10.9% 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 4.4 in October, a considerable improvement versus the past few years, though still below 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 to 38 in November from 37 in October.  Keep in mind a reading below 50 signals a greater number of builders view conditions as poor versus good, now the nineteenth 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 – rose to a stronger than expected +18.7 in November from +10.7 in October. Meanwhile, its counterpart the Philadelphia Fed Index also rebounded to -1.7 in November from -12.8 in October.

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