Implications:  The US service sector continued treading water in July, but data from the ISM Services report add to a growing list of evidence that indicate a slowing economy.  First, the headline: the ISM Services index declined to 50.1 in July, lagging even the most pessimistic forecast from any economics group surveyed by Bloomberg.  Besides the contractionary readings in December 2022, April 2024, June 2024, and most recently in May 2025, that is the slowest pace since the COVID shutdown months.  The details were not much better. Activity among the major industries was split, with eleven out of eighteen reporting growth for the month, while seven reported contraction. The indexes for new orders and business activity both declined in July, falling to 50.3 and 52.6, respectively.  While both indexes sit in modest expansionary territory, uncertainty from trade policy, a pullback in public funding, and rising costs to existing projects are all said to be delaying new investment and activity.  Service companies – once hamstrung with difficulty finding qualified labor – are responding by reducing their headcounts, with the employment index falling deeper into contraction at 46.4, now the fourth month in the last five below 50.  Finally, the highest reading of any category was once again the prices index, which rose to 69.9 in July.  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 is barely up versus three years ago – 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 has been weighing on sentiment, and it remains to be seen whether recent trade agreements from key US trade partners will alleviate some of that.  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 ever-resilient US service sector.

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Implications:  President Trump may see today’s June trade report as validation of his hardline approach: the U.S. trade deficit narrowed to $60.2 billion, the smallest since September 2023. That result was driven largely by a sharp drop in imports, which fell $12.8 billion for the month—far outpacing the $1.3 billion decline in exports. And in one sense, that’s exactly what Trump’s trade agenda aimed to achieve: fewer imports, more domestic production. But whether that’s what’s actually happening is less clear. The drop in trade could reflect a meaningful shift in global supply chains—reshoring, decoupling, and growing domestic output. Or it could simply signal weaker demand at home and abroad. Right now, the data doesn’t offer a definitive answer. U.S. employment growth has slowed, particularly in goods-producing sectors. For a decline in imports to translate into a lasting economic win, it needs to be matched by a revival in U.S. manufacturing and investment. So far, that resurgence remains tentative. In the meantime, the impact on GDP has flipped. Imports subtract from GDP, and their surge in Q1 weighed heavily on growth—net exports alone shaved roughly five percentage points off the growth rate, dragging real GDP down at a 0.5% annualized pace. But as front-loaded imports peaked in March and retreated in Q2, trade turned into a tailwind, helping lift growth in the most recent quarter.  Still, erratic trade policy out of Washington makes it harder to translate monthly trade swings into meaningful GDP forecasts.  Meanwhile, the landscape of global trade continues to shift.  China, once the top exporter to the U.S., has fallen to a distant third place behind Mexico and Canada.  Also in today’s report, the dollar value of US petroleum exports exceeded imports once again. This marks the 40th consecutive month of the US being a net exporter of petroleum products. In fact, through the first half of the year, the petroleum surplus has been higher than any other 6-month period on record.  In other recent news, cars and light trucks were sold at a 16.4 million annual rate in July, up 7.1% from June, and up 3.7% from a year ago.

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It certainly seems hyper-politicization has come to every piece of economic data.  Last week’s data are poster children for this, and the overbroad interpretations of the data by investors, the general public, policymakers, and politicians sow confusion.

Wednesday’s GDP report was a prime example.  The headline was solid, with the real economy growing at a 3.0% annual rate in the second quarter, beating the consensus expected 2.6% pace and rebounding sharply from the 0.5% decline in Q1.  Some reacted like the report heralded a new era of prosperity and was a sign that the Trump Administration’s policies are successful.

Don’t get us wrong, the extension and deepening of the tax cuts enacted in the Big Beautiful Bill (including permanent accelerated business investment expensing) as well as the law’s curbs on the growth rate of Medicaid will promote long-term US economic growth.  We think the same about efforts to reduce discretionary spending, slimming down agencies, sending workers out of DC, and cutting regulation.  But the rebound in economic growth in Q2 wasn’t evidence that agenda is already working.

Instead, the drop in real GDP in the first quarter and rebound in the second is largely a reflection of how businesses reacted to the roll-out of tariffs.  President Trump promised early this year to raise them, and in response, businesses were front-running tariffs in Q1, rapidly filling orders from their foreign suppliers and putting some orders from US producers on the backburner.  Because imports are not domestic production, they are subtracted from purchases when calculating real GDP.  But once higher tariffs actually arrived, businesses slowed orders from abroad and shifted back to US producers.  Hence, GDP volatility.

Putting the two quarters together, real GDP was up at a modest 1.2% annual rate in the first half of the year, which is below the 2.0% average of the past twenty years.

Growth at roughly half the rate of the past twenty years then affected Friday’s Employment report, and the problem flipped from interpretations that were overly optimistic to ones that could be overly pessimistic.  The US economy is certainly not out of the woods when it comes to recession risk.  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 induce a recession, particularly now that the budget deficit is no longer expanding as rapidly as it was in 2023-24.  But Friday’s jobs report does not by itself signal a recession.

Nonfarm payrolls increased 73,000 in July, lagging the consensus expected 104,000.  Worse, payroll gains for prior months were revised down by 258,000, meaning the net loss for the month was 185,000.  Meanwhile, civilian employment, an alternative measure of jobs that includes small-business start-ups, declined 260,000 in July, helping push up the unemployment rate a tick to 4.2% (4.248%, unrounded).  Hence, the widespread negative reaction to the jobs report and evidently cause for Trump to fire the head of the Bureau of Labor Statistics.

But in spite of the weakness in jobs, total private-sector hours worked rose 0.3% in July, as those who were working worked more hours.

Time will tell, but a theory that could explain all this is that stricter immigration enforcement is having a major effect on the job market.  The household survey shows that foreign-born employment is down 1.0 million since January while native-born employment is up 2.5 million.  In other words, recent softness in the labor market could reflect fewer illegal immigrants while native-born (and, potentially, legal immigrants) increase jobs and hours worked.

Whatever your view on immigration enforcement, a slowdown in jobs held by foreign-born workers is exactly what we should expect.

There are many moving parts…tariffs, spending cuts, government job layoffs, and immigration reform.  Over the next several months we may see more of an impact from slower economic growth on the labor market.

But in the meantime, investors should neither be exuberant nor panicked about the economy.  Recession risks remain but economic reports do not show they have arrived.  Moreover, if we do get a recession, it is unlikely to be severe.  In the meantime, better policies take time to have an impact.

Brian S. Wesbury – Chief Economist

Robert Stein, CFA – Deputy Chief Economist

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Implications:  Manufacturing activity continued to soften in July, with the index lagging consensus expectations and declining to 48.0. This makes five consecutive months that the ISM Manufacturing index has been below 50, continuing a pattern that stretched all of 2023 and 2024.  While many believed the downturn was over when the index briefly rose above 50 in January and February, the subsequent five months of weak readings suggest caution is still warranted. Uncertainty from U.S. trade policy and, more recently, escalating conflict in the Middle East could be weighing on the sector, but these readings are consistent with a swath of other recent economic data that indicate a slowing economy.  Looking at the details of the report, seven of the eighteen major industries reported growth in July, versus ten that reported contraction.  Notably, of the six largest manufacturing industries, none expanded in July.  Despite the slight decline in the overall index both the new orders index and production index increased in July, albeit to sluggish levels (47.1 and 51.4, respectively).  Order books were weak before this year and the added business uncertainty from on-again/off-again tariffs has put many customer orders on pause until stability returns.  In turn this has severely undermined their hiring efforts, as the employment index fell to the lowest level excluding the COVID shutdown months since 2009, with more than triple the industries (eleven) reporting lower employment in July versus higher (three).  Perhaps the worst part of the report is that inflation pressures remain even while manufacturing stagnates.  The prices index declined to 64.8, which is high by historical standards, but below post COVID inflation levels.  We will be watching the M2 measure of the money supply closely – it is roughly unchanged versus three years ago – as a signal for if these pressures will turn inflationary.  In other news this morning, construction spending declined 0.4% in June, led by a large drop in homebuilding as well as declines in office and manufacturing projects.

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Implications:  The headlines on the labor market were soft, consistent with weak 1.2% annualized economic growth in the first half of the year.  However, new policies that strictly enforce immigration laws are probably also weighing-down the job numbers.  Nonfarm payrolls increased 73,000 in July, lagging the consensus expected 104,000.  Worse, payroll gains for prior months were revised down by 258,000, meaning the net loss for the month was 185,000.  We like to follow payrolls excluding three sectors: government, education & health services, and leisure & hospitality, all of which are heavily influenced by government spending and regulation (including COVID lockdowns and re-openings).  This measure of “core payrolls” declined 1,000 in July, the third straight monthly drop, and is down 82,000 versus three months ago.  Meanwhile, civilian employment, an alternative measure of jobs that includes small-business start-ups, declined 260,000 in July, helping push up the unemployment rate a tick to 4.2%.  Bottom line: the job totals are not looking good.  However, in spite of job weakness, total private-sector hours worked rose 0.3% in July, as those who were working worked more hours.  A theory that could explain all this is that stricter immigration enforcement is having an effect.  The household survey shows that the foreign-born population (age 16+) has dropped 1.9 million since January while foreign-born employment is down 1.0 million.  At the same time, native-born employment has grown 2.5 million.  In other words, recent softness in the labor market could reflect fewer illegal immigrants while native-born (and, potentially, legal immigrants) increase jobs and hours worked.  On the inflation front, average hourly earnings rose 0.3% in July and are up 3.9% versus a year ago.  However, these earnings are up only 3.4% annualized in the past six months, which we think should help the Federal Reserve re-start rate cuts in September.  Notably, the Trump Administration is making progress reducing federal payrolls, which when we exclude the Post Office and Census workers are down 75,000 versus January, the largest six-month drop on record going back to at least 1990.  In time, we think a smaller government should pay dividends in the form of faster economic growth.

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Investor borrowing to fund stock purchases—known as margin debt—surged past $1 trillion in June 2025, eclipsing the previous record of $937 billion set in January. Margin debt doesn’t cause market crashes—but it certainly can magnify them. In this week’s “Three on Thursday,” we look at what margin debt is telling us now. For further insight, click on the link below.

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Implications:  Consumers started the summer on a healthy note, with both income and spending rising 0.3% in June.  Unfortunately, the news on the income side is not as strong as the headline appears. Private-sector wages and salaries rose a meager 0.1% in June – the smallest monthly increase in close to a year – although they are up 4.7% in the past year.  The largest driver of income gains in June was once again government transfer payments, up 1.0%, as a rise in social security payments led the category, while government sector wages and salaries increased 0.6% in June and are up 5.5% from a year ago.  These government led drivers are not reliable (or desirable) long-term sources of income, so while incomes rose in June, the mix of where that spending power came from was weak.  What was more constructive was the 0.3% rise in personal consumption, where spending on goods rose 0.5% while services spending increased 0.3%.  This may reflect tariff impacts on goods prices, but as we have noted in other pieces on inflation, higher consumer spending in some categories is largely being offset by declines in other categories, and inflation has shown little net movement in response to the tariffs.  PCE prices, the Feds preferred inflation metric did run a little hot in June, up 0.3%, and the year ago reading rose to 2.6% from 2.4% in May, but that largely reflects weak inflation readings from this time last year rolling off the books.  The six-month annualized change in PCE prices has been trending lower and with M2 growth running below the historical 6% rate, we believe inflation will continue to diminish in the months ahead. We believe that the Fed should have restarted the rate cut process yesterday, but now we must wait and see how the economic data, both inflation and employment, progress between now and September. In other recent news on the employment front, initial claims for unemployment insurance rose 1,000 last week to 218,000.  Continuing claims were unchanged at 1.946 million.  These figures are consistent with our expectation that tomorrow’s employment report will show around 132,000 nonfarm jobs created in July. On the housing front, pending home sales, which are contracts on existing homes, declined 0.8% in June following a 1.8% rise in May, suggesting existing home sales (counted at closing) will be roughly unchanged in July.  Finally on the manufacturing front, the Chicago Purchasing Managers Index (PMI) rose to 47.1 in July from 40.4 in June, signaling activity continues to contract, but at a slower pace than prior months.

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The Federal Reserve held rates steady for a fifth consecutive meeting, though murmurs have begun in the Fed ranks that the time for more cuts is approaching. Yet while the Fed statement acknowledged the weakening of fundamentals since the last meeting in June, today’s press conference suggests Powell and company are plenty willing to sit on the sidelines.

Starting with the Fed statement, the most notable change from June came in that two voting members – Fed Vice Chair for Supervision Michelle Bowman and Fed Governor Christopher Waller – dissented from today’s decision to hold rates steady, instead stating that they would have preferred a 25-basis point cut.  This is the first time since 1993 that two members of the Fed Board of Governors have dissented at a meeting. Other changes to today’s release included a softening in language around GDP growth, from June’s comment that activity “continued to expand at a solid pace” to now stating growth “moderated in the first half of the year”.  For our take on the Q2 GDP report released this morning, click here.  Finally, the Fed removed language that economic uncertainty “has diminished” and now simply notes that uncertainty remains elevated.  That seems a bit odd given the recent string of trade agreements that have removed unknowns around tariff rates as well as the passage of the OBBB which has removed uncertainty about the path forward on tax rates.

During the press conference, Chair Powell saw pushback from the start, as reporters probed for a better understanding of what, exactly, the Fed is waiting for.  Powell once again stated that the current level of the Fed funds rate is only moderately restrictive and isn’t having a dampening impact on the economy, yet at the same time acknowledged that real (inflation- adjusted) economic growth has slowed to a 1.2% annualized rate in the first half of 2025 from the 2.5% pace seen in 2024.  On the employment side he brushed off the slowing in nonfarm payrolls growth (nonfarm payrolls gains have averaged 130,000 per month through the first half of this year, down from 168,000 per month in 2024) and instead put the focus on the unemployment rate which has stayed in a relatively steady range.   

Even when it came to inflation, Powell wasn’t let off the hook.  In the five months since President Trump entered office, CPI has increased at a 1.8% annualized rate, below the Fed’s 2% target. Yes, year-ago readings remain elevated because of weak inflation data twelve months ago, but the focus should be on the current trajectory, not events well past.  But rather than acknowledge that tariffs may not be as inflationary as the Fed has anticipated, they have taken the same track as they did when they insisted inflation was transitory back in 2020 and 2021. It’s not that their models are wrong, we just have to wait longer. 

We believe that the Fed should act now, just as we believed they should have acted sooner to contain the rise in inflation from the COVID-era money printing, but we don’t think they read the Monday Morning Outlook.  While we wait on the Fed, we will continue to dive deeper into the data through our MMOs, Data Watches, Three on Thursday reports, and research pieces that we hope give you a window into how – and why – our views differ on both where we stand today, and where we see the economy heading in the months ahead.

Brian S. Wesbury – Chief Economist

Robert Stein, CFA – Deputy Chief Economist

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Implications:  Real GDP growth rebounded sharply from the decline in the first quarter, growing at a 3.0% rate in Q2.  However, this is not a signal of a new era of prosperity or that the underlying trend is now 3.0%.  Instead, it’s largely a reflection of how businesses reacted to the introduction of tariffs this year.  President Trump promised early this year to raise tariffs.  In response, businesses were front-running tariffs in Q1, rapidly filling orders from their foreign suppliers and putting some orders from US producers on the backburner.  As a result, we got lower real GDP in Q1.  But once higher tariffs arrived, businesses slowed orders from abroad and shifted some back to US producers, resulting in a rebound in real GDP.  Putting these two quarters together, real GDP is up at a modest 1.2% annual rate in the first half of the year, below the 2.0% average of the past twenty years.  In terms of the details for the second quarter, net exports added 5.0 percentage points to the growth rate in Q2, the largest contribution for any quarter since at least the 1940s (after Q1 was a record drag).  Meanwhile, with fewer imports, inventories were a 3.2 point drag on growth in Q2.  The good news is that inventories are very likely to help support growth in the third quarter.  We like to follow what we call “Core” Real GDP, which is consumer spending, business fixed investment, and home building, and excludes the most volatile categories like government purchases, inventories, and international trade.  Core GDP grew at a modest 1.2% annual rate in Q2, a 1.6% annual rate in the first half of the year, but is up a respectable 2.4% from a year ago.  Perhaps the best news is more evidence that the Federal Reserve has room to modestly cut rates.  Nominal GDP (real GDP plus inflation) is up 4.5% from a year ago, compared to 5.7% in the year ending in the second quarter of 2024.  The drop in the growth rate of nominal GDP signals that monetary policy has been tight and the 4.5% trend is already very close to the Fed’s target for short-term rates.  Note that GDP prices rose at a 2.0% rate in Q2, right at the Fed’s inflation target.  If the Fed doesn’t cut rates, we are headed for inflation below the 2.0% target.  In other news this morning, ADP reported private payrolls up 104,000 in July, consistent with our forecast for an increase in nonfarm payrolls of 132,000 to be reported on Friday.  On the housing front, home prices declined slightly in May, the second consecutive drop.  The national Case-Shiller index fell 0.3% for the month while the FHFA index declined 0.2%.  However, both indexes remain higher than a year ago, the Case-Shiller by 2.3% and the FHFA by 2.8%.  We expect very modest price gains in the year ahead.

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President Trump announced higher tariffs were on the way almost as soon as he took office.  As a result, businesses focused on buying foreign goods in advance, to front run those tariffs, putting some of their purchases from domestic producers on the backburner. The result was a massive surge in imports in Q1 that made trade the largest drag on real GDP growth for any quarter since at least the 1940s.

Now trade has gone in reverse, with purchases shifted back to US producers, which means trade will make a large contribution to real GDP in Q2 and real GDP will rebound sharply.  How much it will rebound will be unclear until Tuesday morning, when we get a report on June trade and inventories, which could lead to substantial revisions in our forecast.

In the meantime, we are forecasting 3.0% annualized growth in Q2 versus a consensus expected 2.4%.  But don’t get too excited if we’re right.  Real GDP has averaged 2.0% per year the past twenty years, so one quarter with 3.0% growth after a quarter of -0.5% is not a sign of an economic boom.

Consumption: Auto sales declined at an 8.6% annual rate in Q2 while “real” (inflation-adjusted) retail sales excluding autos rose at a 1.0% rate and real service spending appears up at a 1.0% pace.  This brings our estimate of real consumer spending on goods and services, combined, to a 0.5% rate, adding 0.3 points to the real GDP growth rate (0.5 times the consumption share of GDP, which is 68%, equals 0.3).

Business Investment:  We estimate a 2.1% growth rate for business investment, with gains in equipment and intellectual property leading the way.  A 2.1% growth rate would add 0.3 points to real GDP growth.  (2.1 times the 14% business investment share of GDP equals 0.3).

Home Building:  Residential construction declined at about a 5.0% rate in the second quarter, possibly reflecting a lack of workers to build homes while strict immigration enforcement makes more units available for rent.  A 5.0% annualized decline would be a 0.2 point drag on real GDP growth.  (-5.0 times the 4% residential construction share of GDP equals -0.2).

Government:  DOGE and other Trump Administration efforts are cutting back on federal payrolls and transfers to NGOs, but only direct government purchases (not government salaries or transfer payments) count when calculating GDP.  We estimate these purchases were up at a 1.2% rate in Q2, which would add 0.2 points to the GDP growth rate (1.2 times the 17% government purchase share of GDP equals 0.2).

Trade:  The trade deficit plummeted in Q2 as businesses stopped front-running tariffs.  This forecast may change a great amount when the “advance” report on trade arrives the morning of Tuesday July 29, but for now we’re projecting net exports will increase the Q2 real GDP growth rate by 3.4 percentage points.

Inventories:  After an import-related surge in Q1, inventories should grow much more slowly in Q2, generating what we are estimating as a 1.0 percentage point drag on real GDP growth.

Add it all up, and we get a 3.0% annual real GDP growth rate for the second quarter, a sharp rebound from the decline in Q1, but not a sign of an economic boom.

Brian S. Wesbury – Chief Economist

Robert Stein, CFA – Deputy Chief Economist

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