Implications:  The US manufacturing sector showed signs of life in the first month of the new year. Looking at the headline, the ISM Manufacturing index beat expectations in January and rose to 50.9 – the first expansionary reading since October 2022.  Digging into the details, growth in January was split with an equal number of industries (eight) reporting expansion vs. contraction, while two reported no change.  The good news is that both demand and output were responsible for the headline increase; the new orders index rose to 55.1, the highest level for the category since 2022.  Meanwhile, production activity pushed higher with the index rising to 52.5, the first expansionary reading in eight months.  Survey comments were modestly positive, penciling in steady to strong customer demand for 2025.  It’s very possible a “Trump Bump” could be showing up in the new orders data, as businesses get more certainty on policy framework from the new administration and can look forward to an easier regulatory environment in the next four years, as well as lower tax rates on profits. This newfound optimism can perhaps most easily be seen in their hiring efforts, as the employment index jumped to 50.3 from 45.4, the first expansionary reading in eight months.   However, comments were also mindful of impacts from potential new tariffs on materials used for manufacturing, with concerns of shortages and cost pressures resulting (the January ISM survey was conducted before President Trump announced 25% tariffs on imports from Canada and Mexico). The issue is that inflation was already a major problem in the manufacturing sector.  Prices paid by companies rose again in January and the pace accelerated, with the index rising to 54.9 from 52.5. Given that the prices index has been above 50 for all but one month in the past year despite sluggish activity, it’s clear the embers of inflation remain.  In other recent news, construction spending jumped 0.5% in December, led by large increases for homebuilding and highway & street projects.

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The Federal Reserve made it clear on Wednesday that it’s not about to cut short-term interest rates again anytime soon, which is good news if you’d like to see the Fed live up to its goal of bringing inflation down to 2.0%.

After all, progress toward that 2.0% goal has stalled.  PCE prices, the Fed’s favorite measure of inflation, increased 2.6% in 2024, barely better than the 2.7% climb in the twelve months ending December 2023.  Core prices, which exclude food and energy, climbed 2.8% last year, slightly above overall inflation.

Meanwhile, SuperCore prices, which exclude food and energy, but also all other goods and housing rents, rose 3.5% in 2024 versus a 3.4% climb in the year ending in December 2023.  That’s right…SuperCore inflation was worse in 2024 than in 2023!

We like to pay attention to this measure not because we think it’s a great inflation measure but because a few years ago the Fed was telling investors and the general public to watch it, but then mysteriously stopped talking about it when SuperCore stopped telling the story of rapid inflation reduction the Fed wanted to tell.

Now tariffs are coming, with the Trump Administration raising them on imports from Canada, Mexico, and China.  Each of these countries is saying some retaliatory tariffs are likely on the way, as well.  How this will affect inflation, however, is often misunderstood. 

Yes, tariffs will put upward pressure on prices for any items being tariffed.  But ultimately inflation is a monetary phenomenon and as long as the new tariffs are not accompanied by a looser monetary policy – and it doesn’t look like they will be – then higher prices for those products means consumers have less money to spend on other goods and services, putting offsetting downward pressure elsewhere.

In the meantime, expect the Fed to use the tariffs as a reason to hold the line on short-term interest rates.  Especially with the press focusing on the prices that do go up because of those tariffs.

The Fed is probably happy that it has something else to blame for inflation and will be less reactive to incoming data than it normally is.  Keep this in mind when you see the onslaught of economic reports over the next two weeks, including employment, retail sales, industrial production, and inflation.

If, as we expect, economic data begin to show signs of a slowdown, the Fed (and the market) will not immediately price in rate cuts.  On the other hand, if the Fed does react to a slowdown in the economy and starts to increase the money supply too much, then stagflation becomes a problem.  Either way, the equity market faces some serious headwinds.  The era of easy everything is coming to an end.

Brian S. Wesbury – Chief Economist

Robert Stein, CFA – Deputy Chief Economist

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Implications:  Consumers ended 2024 on a high note, with strong holiday spending backed by healthy income growth.  Unfortunately for the Fed, inflation didn’t take the holidays off.  Personal income rose 0.4% in December and is up 5.3% in the past year.  Private-sector wages and salaries represented the bulk of income gains in December, up 0.4% on the month and up 5.6% in the past year.  That said, government activity continues to run even hotter, as pay in the public sector rose 0.6% in December and is up 6.5% in the past year, hovering near the largest twelve-month increase in decades. At the same time, government benefit payments to individuals are up 8.1% in the past year, also near the largest 12-month increase (excluding the COVID stimulus period) in more than a decade.  We don’t think the growth in government pay – or massive government deficit spending – is either sustainable or good for the US economy, which is why we’re hoping recent policy changes in DC represent a shift in thinking on the growth of government.  On the spending side, personal consumption jumped 0.7% in December (+0.9% when including upward revisions to prior months) with growth virtually across the board.  Spending on services rose 0.6% in December and is up a strong 6.7% from a year ago.  Goods spending rose a robust 0.9% in December, but is up a more modest 3.5% from a year ago.  Unfortunately, inflation also rose at an above trend rate in December.  PCE prices, the Fed’s preferred measure of inflation, increased 0.3% in December and are up 2.6% in the past year, the third month in a row that year-ago readings have ticked higher.  And considering that PCE prices rose 2.7% in the twelve-months ending December 2023, it means the Fed made virtually no progress in the inflation flight over the past year. The improvement in “core” prices (which exclude the ever-volatile food and energy categories) wasn’t much better, rising 0.2% in December and up 2.8% versus a year ago, compared to a 3.0% increase for the twelve months ending December 2023.  Earlier this week the Fed signaled that they are now in wait and see mode after cutting by 100 basis points in the back half of 2024, saying the path forward for rates is more uncertain, and cuts are likely to move more slowly in 2025.  Risks remain that activity in Washington could translate to a pullback in government spending in 2025 and beyond, which may cause short-term economic pain before longer term gain.  If the Fed reacts with an overly aggressive path of cuts to offset that pain, it could bring with it a pickup in the M2 measure of money which would lead to a return of inflation pressure. In other recent news on the housing front, pending home sales, which are contracts on existing homes, fell 5.5% in December following a 1.6% increase in November, suggesting a decline in existing home sales (counted at closing) in January.

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In this week’s “Three on Thursday,” we explore how high taxation and income redistribution harm living standards, stifle economic growth, and hinder wealth creation, using Paul Zane Pilzer’s Fish Story from his 1990 book, Unlimited Wealth. Wealth isn’t a finite resource to divide—it’s generated through innovation, productivity, and investment. High taxes and redistribution, though often well-meaning, literally rob the US economy of the benefits of technology. 

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Implications:  The US economy grew at a 2.3% annual rate in the fourth quarter, slightly slower than the consensus expected, but slightly faster than the average annualized pace of 2.1% in the past twenty years.  The best news in the report was that what we think of as Core Real GDP – consumer spending, business fixed investment, and home building, and excluding the more volatile categories like government purchases, inventories, and international trade – grew at a 3.2% annual rate in the fourth quarter and was up 3.0% versus a year ago.  However, there were economic blemishes, as well.  Business fixed investment – equipment, commercial construction, and intellectual property – declined at a 2.2% annual rate in Q4 in spite of the boom in AI spending, the first drop since 2021.  These investments are crucial to lifting productivity growth in the years ahead.  Meanwhile, much of the gain in Real GDP was accounted for by consumer spending, which grew at a 4.2% annual rate and is up 3.2% in the past year.  The reason that’s a problem is because some of this growth in consumer spending is unsustainable; the personal saving rate declined to 4.1% in the fourth quarter, well below the 6.7% rate that prevailed pre-COVID. A move by consumers to reassert a higher saving rate again could mean an abrupt slowdown in the growth of consumer spending as well as the production of those goods and services for consumers.  We also can’t help but notice the continued abnormally large contribution from federal government spending, which grew at a 3.2% rate in Q4 and is up 4.0% in the past year.  Eventually the rapid growth in government will end, and the economy will pay a temporary price.  On the inflation front, GDP prices rose at a 2.2% rate in Q4 and are up 2.4% in the past year, still above the Federal Reserve’s 2.0% target.    In other news this morning, initial claims for unemployment insurance declined 16,000 to 207,000 last week; continuing claims dropped 42,000 to 1.858 million.   These figures signal continued job growth in January.  In other recent news, the Richmond Fed index, a measure of mid-Atlantic factory activity, rose to -4 in January after a -10 reading in December. The most under-reported indicator of the week was on the M2 measure of the money supply, which grew at a moderate 4.9% annual rate in December and is up 3.9% from a year ago.  M2 soared in 2020-21, heralding the inflation surge that followed.  Then M2 fell in 2022-23, signaling some of the drop in inflation.  But we just finished 2024 with inflation still above the Fed’s target.  As a result, the Fed must be careful with any rate cuts to make sure M2 doesn’t surge again.  Look for the Fed to hold the line against rate cuts through at least the Spring unless the economy takes a sudden turn for the worse.

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Following 100 basis points in rate cuts through the back half of 2024, the Fed started 2025 with a pause, placing itself in wait and see mode for the foreseeable future. 

Starting with today’s FOMC statement, there were a few language changes worthy of note.  On the employment front, prior comments that labor market conditions have eased and the unemployment rate has risen, now state that the unemployment rate has stabilized and labor market conditions “remain solid.” With regards to inflation, the FOMC removed language that noted “progress towards the Committee’s 2 percent objective” and now simply state that inflation “remains somewhat elevated.” Both of these suggest more hawkishness, or at least less dovish news. 

If there was one consistent theme Powell himself stressed throughout his press conference, it’s that the Fed believes their current policy stance is well positioned to respond if and when the data demand it.  If the employment situation unexpectedly weakens, they stand ready to cut, but likewise they stand confident that keeping rates at current levels is enough to put continued pressure on inflation towards their 2 percent target.

It’s worth noting that the FOMC previously expressed confidence in their policy stance back in 2020 when they felt any rise in prices from massive government stimulus would be “transitory”. They also felt confident when they acknowledged that inflation wasn’t so transitory, but forecast a modest pace of rate hikes would have inflation back down to 2 percent by the time 2024 was out. Yet here we stand, continuing an inflation fight that has stalled above target, despite rate hikes that went well past forecasted levels.  

And now a new battle in Washington has begun.  From tax cuts and deregulation which stand to boost businesses, to a clamping down on government excess which could temporarily slow the outsized deficit spending that has propped up economic growth. We may experience pain before the gain, as the economy moves to more sustainable footing. Along the way, the Fed is likely to spend much of this year reactively, though their guideposts have proven less than reliable.

What will we be watching?  If M2 growth remains modest, both inflation and economic growth will slow, and the Fed will have room to continue cuts. If, however, rate cuts (or movements by the Treasury to draw down their checking account at the Fed and put that money back into the economy) lead to a rapid rise in M2 growth, the Fed has shown an active neglect of the warning signs that would have preempted the inflation debacle to begin with.

Brian S. Wesbury – Chief Economist

Robert Stein, CFA – Deputy Chief Economist

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Implications:  New orders for durable goods fell for the fourth time in five months in December, and are down 3.9% in the past year.  That said, the details of today’s report were not quite as weak as the headline.  Transportation drove orders lower in December, but can swing wildly from month to month as aircraft orders tend to come in chunks rather than steadily over time.  That was the case once again in December, as commercial aircraft orders fell 45.7%.  Excluding the transportation sector, orders for durable goods rose 0.3%.  Fabricated metal products led non-transportation orders higher, up 1.2% in December, while electrical equipment (+0.3%), machinery (+0.2%), and computers and electronic products (+0.1%) also rose.  These gains were partially offset by a 0.6% drop in orders for primary metals.  The most important number in the release, core shipments – a key input for business investment in the calculation of GDP – rose 0.6% in December following healthy 0.4% increases in October and November. These shipments rose at a 3.0% annualized rate in Q4 versus the Q3 average, which represents a welcome return to positive movement following declines in shipments in both the second and third quarters of the year.  However, overall orders for durable goods – both including and excluding transportation – haven’t kept pace with inflation over the past twelve months, with headline orders down in the past year.  And now that the Trump Administration is back in Washington with a mandate to cut taxes, regulations, and the size of government, we expect volatility in the data to continue in the months ahead as businesses figure out how the new policy environment changes the outlook for investment and growth.  In turn, the Federal Reserve will navigate what these changes mean for the path of inflation.  There is plenty of potential for both progress and payback in 2025, as the US works to wean itself off outsized deficit spending and on to a more sustainable growth path.  There may be pain before the gain.  In other news this morning, the home price indexes are telling a story of moderate gains.  The national Case-Shiller index rose 0.4% in November and is up 3.8% from a year ago; the FHFA index rose 0.3% in November and is up 4.2% from a year ago.

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Implications:  New home sales continued to rebound in December from hurricane-related weakness in prior months, rising for the second month in a row to finish 2024 on a healthy note.  Looking at the big picture, buyers purchased 682,000 homes, up 2.4% from 2023. That is the second calendar year gain in a row, but sales still remain well below the highs of the pandemic. Though we expect the upward trend in sales to continue in 2025, the housing market continues to face challenges. While thirty-year fixed mortgage rates were falling in the lead up to the initial Fed rate cut announcement in September, that has reversed with rates back above 7%. One piece of good news for potential buyers is that, even though prices are up in the past year, the median sales price of new homes is down 7.2% from the peak in October 2022. Meanwhile, the Census Bureau reports that from Q3 2022 to Q3 2024 (the most recent data available) the median square footage for new single-family homes built fell 6.0%. So, it does look like a small part of this decline reflects a lower price per square foot as developers cut prices. While that decline is modest, it represents a stark reversal from the 45% gain in the price per square foot from 2019 to 2022.  That said, most of the drop in median prices is likely due to the mix of homes on the market including more lower-priced options as developers complete smaller properties. Supply has also put more downward pressure on median prices for new homes than existing homes.  The supply of completed single-family homes is up over 280% versus the bottom in 2022. This contrasts with the market for existing homes which continues to struggle with an inventory problem, often due to the difficulty of convincing current homeowners to give up the low fixed-rate mortgages they locked-in during the pandemic.  While the future cost of financing remains a question, lower prices and an abundance of inventories are giving potential buyers a wider array of options will help fuel new home sales in 2025.

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We still believe the odds of a recession are higher than most investors think.  Monetary policy tightening started back in 2022 and inflation remains above the Federal Reserve’s 2.0% target, which means the Fed will be reluctant to get loose anytime soon.

Meanwhile, the federal budget deficits in the past two years have averaged about 6.5% of GDP, which is enormous considering the US was not at war and the unemployment rate averaged about 4.0% during the same timeframe.  We think those deficits have temporarily masked or hidden some of the pain the economy will eventually feel from the tightening of monetary policy compared to a few years ago.  Now, in the short run, reducing government spending, like on “green energy” and Medicaid may temporarily reduce economic growth.

However, in the meantime, the economy continued to grow in the fourth quarter.  Innovators and entrepreneurs in high-tech industries and elsewhere have been overcoming government obstacles to push the economy forward.  And if the new Administration in Washington moves swiftly to deregulate, there is a chance this will continue.

For the fourth quarter itself, we estimate that Real GDP expanded at a 2.8% annual rate, mostly accounted for by growth in consumer spending.  (This 2.8% estimate is not yet set in stone; reports on Tuesday about durable goods and Wednesday about international trade and inventories might lead to an adjustment.)

Consumption: Auto sales soared at a 26.4% annual rate in Q4, the fastest pace for the year, while “real” (inflation-adjusted) retail sales excluding autos climbed at a tepid 1.2% rate.  Real service spending appears up a moderate 2.3% pace, bringing our estimate of real consumer spending on goods and services, combined, to a 3.1% rate, adding 2.1 points to the real GDP growth rate (3.1 times the consumption share of GDP, which is 68%, equals 2.1).

Business Investment:  We estimate a 2.9% growth rate for business investment, with gains in intellectual property leading the way and business investment in equipment as well as commercial construction both up slightly.  A 2.9% growth rate would add 0.4 points to real GDP growth.  (2.9 times the 14% business investment share of GDP equals 0.4).

Home Building:  Residential construction rose at a moderate pace in the fourth quarter, buffeted between a lack of housing supply (which should boost growth) and higher mortgage rates (which should dampen construction).  Home building looks like it grew at a 2.5% rate, which would add 0.1 points to real GDP growth.  (2.5 times the 4% residential construction share of GDP equals 0.1).

Government:  Only direct government purchases of goods and services (not transfer payments) count when calculating GDP.  We estimate these purchases were up at a 2.3% rate in Q4, which would add 0.4 points to the GDP growth rate (2.3 times the 17% government purchase share of GDP equals 0.4).

Trade:  The trade deficit looks like it was stable in the fourth quarter, with neither imports nor exports changing much on net versus the third quarter, in spite of monthly volatility due to the threat of, and actual, port strikes.  We’re projecting net exports will have zero net influence on Q4 real GDP growth.

Inventories:  Inventory accumulation looks like it was slightly slower in Q4 than Q3, translating into what we estimate will be a 0.2 point subtraction from the growth rate of real GDP.

Add it all up, and we get a 2.8% annual real GDP growth rate for the fourth quarter.  As we’ve been saying, not a recession yet, but that doesn’t mean that the US economy is out of the woods.

Brian S. Wesbury – Chief Economist

Robert Stein, CFA – Deputy Chief Economist

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Implications:  In spite of hitting a full year total that was the lowest in nearly 30 years, existing home sales finished out 2024 on a healthy note. Notably, sales are up 9.3% in the past year, the fastest 12-month gain since 2021. While the recent recovery is positive news, sales activity still has a long way to go.  The 4.240 million pace of December is well below the roughly 5.250 million annual pace that existed pre-COVID, let alone the 6.500 million pace during COVID.  One problem recently is that since the Federal Reserve began cutting interest rates in September 2024, 30-year fixed mortgage rates have risen back above 7%. So at least so far, the widely anticipated shot in the arm to the housing market from improved affordability hasn’t happened and most buyers continue to sit on the fence. Meanwhile, home prices are rising again with the median price of an existing home up 6.0% from a year ago. Speaking of price, it looks like the housing market has bifurcated.  While the sales of homes worth $250,000 and above are up at double-digit percent rates in the past year, sales for homes below this threshold have continued to fall. On a positive note this demonstrates that, at least at the higher end of the market, both buyers and sellers are beginning to adjust to the new reality of higher rates. However, it also suggests that inventory at the lower end of the price spectrum has all but disappeared after the inflation of the past few years, pricing whole swaths of potential buyers out of the market. Moreover, 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 a major impediment to activity by limiting future existing sales (and inventories).  However, there are signs of progress with inventories rising 16.2% in the past year.  That has helped push the months’ supply of homes (how long it would take to sell existing inventory at the current very slow sales pace) to 3.3 in December, a considerable improvement versus the past few years, but still below the benchmark of 5.0 that the National Association of Realtors uses to denote a normal market.   A tight inventory of existing homes means that while the pace of sales looks like 2008, we aren’t seeing that translate to a big decline in prices.  In other recent news on the labor market, initial jobless claims rose 6,000 last week to 223,000, while continuing claims increased 46,000 to 1.899 million.  These figures are consistent with continued job growth in January, but at a slower pace than the year before.  Finally, the Kansas City Fed Manufacturing Index, a measure of factory sentiment in that region, remained unchanged at -5 in January.

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