In spite of severe polarization on so many issues, there is at least one thing that Americans agree on across the entire political spectrum, left, right, and center.  That is: At some point in the past sixty years, or so, something major went wrong with the US economy and it is still causing problems today.

What are those problems?  Different political tribes, and their respective economists and commentators, may explain it differently, but they generally agree that economic growth and productivity increases are too slow, the distribution of income is too skewed toward the upscale, housing is unaffordable, and there is too little manufacturing in the US.

The left often blames “greed” and “capitalism,” or maybe just “late capitalism,” and proposes to raise taxes on the rich.  If you listen closely, they argue that capitalism’s worst evil is that it causes “climate change,” which just makes every other problem worse.  They want higher tax rates on regular income and investment income, and even talk of a wealth tax on unrealized capital gains.  Then, by redistributing that money to the appropriate people and places, the US could fix all the economic problems that confront it.

On much of the political right there is a different narrative, which was recently expressed in depth by former US Trade Representative Robert Lighthizer in an interview with Tucker Carlson.  In his telling, the movement toward freer world trade over the past forty or fifty years, what he calls “hyper-globalization,” is at the root of many economic and social problems.

As manufacturing went global, the fabric of the US changed.  Not only did the US economy slow, but the structure of the country changed.  He argues that many places have lost their sense of community, compared to the immediate post-World War II era in which rich, poor, and middle class, often lived in the same towns.

His argument is bolstered by the data.  Industrial production data show that manufacturing has grown just 4.3% in the past twenty-five years.  Not 4.3% annualized, we mean 4.3% total.  This translates to 0.2% annualized growth.  In some cases, entire industries are uncompetitive without large government contracts, like shipbuilding.

Both narratives, in our opinion, are trying to deal with the symptoms of the underlying problem, not the problem itself.  This is similar to the argument that our food supply makes us less healthy (obesity, diabetes, compromised immune systems).  By treating these symptoms, we are ignoring the root cause.

There is an “elephant in the room” and almost no one incorporates it into their analysis.  That elephant is the massive growth in the size and scope of the federal government.  Excluding defense (in order to understand the impact of the bureaucracy and redistribution) federal government spending was 7% of GDP in the 1950s.  That rose to 10% in the 1960s and then 14% in the 1970s.  It stabilized there between 1980 and 2000, but then started growing again.  So far in the 2020s, non-defense government spending has averaged 23% of GDP, more than triple its size in the 1950s.

Every dime the government spends is taken from the private sector, so the bigger the government gets, the smaller the private sector becomes.  Adding all government spending – federal, state and local – with the cost of regulation, and government directs or prevents more than 50% of all output.  No wonder saving rates are low, houses are unaffordable, manufacturing has moved, and economic growth rates have stumbled.

In many respects we have already abandoned capitalism.  Abandoning it harder, or moving toward protectionism, is not the real answer.  We believe shrinking the size of government itself would fix most of our problems, certainly the economic ones.

There is enormous upside potential (long-term, not short term) if DOGE helps the federal government get its fiscal house in order and downsizes government spending.  Yes, we know it’s disruptive in the near term, but this is the kind of disruption that deals with the major cause of our problems, not just the symptoms.

Brian S. Wesbury – Chief Economist

Robert Stein, CFA – Deputy Chief Economist

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Implications:  Existing home sales surprised to the upside in February, rebounding a healthy 4.2%. Sales activity has been characterized by fits and starts since 2022, with any positive upward trend eventually running into a ceiling of around 4.300 million.  While the 4.260 million pace of February is getting close to that apparent ceiling, it’s important to remember that it is still 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 lower interest rates from the Federal Reserve (who have since paused rate cuts) haven’t translated into lower 30-year fixed mortgage rates, which remain near 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 3.8% from a year ago. Speaking of price, it looks like the housing market has bifurcated.  While the sales of homes worth $750,000 and above are up 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 at the lower end of the price spectrum inflation has priced many Americans out of the existing home market.  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. Finally, 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 17.0% 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 3.5 in February, 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 3,000 last week to 223,000, while continuing claims increased 22,000 to 1.892 million.  These figures are consistent with continued job growth in March, but at a slower pace than in 2024.  Finally, the Philadelphia Fed Manufacturing Index, a measure of factory sentiment in that region, fell to a still healthy 12.5 in March from 18.1 in February.

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With a renewed focus on protecting American industries and generating additional revenue, President Trump’s administration has intensified its tariff policies. These measures could have a significant impact on overall U.S. growth and revenue, but their impact varies widely across different states. In this edition of “Three on Thursday,” we examine the largest import partners for each U.S. state, identify their top export markets, and analyze the role of trade as a share of state GDP. 

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The Federal Reserve held rates steady today, but downgraded the outlook for economic growth in the year ahead.  Policy changes in Washington, looming tariffs, and a cautious consumer have made “uncertainty” the new favorite word in the Fed’s vocabulary.

Starting with today’s FOMC statement, there were a few changes worthy of note.  Prior comments that the risk to achieving the Fed’s employment and inflation goals as “roughly in balance” were replaced with a simple and direct statement that “Uncertainty around the economic outlook has increased.”  The other is that beginning in April the Fed will slow the pace of Treasury security run-off from $25 billion per month down to $5 billion.  Agency debt and agency mortgage-backed securities will continue to be redeemed at a pace of $35 billion per month.  

The Fed also released updated economic projections, showing real GDP will grow at 1.7% annual rate this year versus a prior forecast of 2.1%.  Meanwhile, PCE prices – the Fed’s preferred measure of inflation – are now forecast to rise 2.7% in 2025, slightly more than the prior forecast of 2.6%.  

While slower growth could suggest for a faster pace of rate cuts, higher inflation suggests the Fed should wait longer to act.  The Fed essentially ruled these changes offset and made no change to their expectation that two rate cuts will be appropriate in 2025.  That said, the number of FOMC members who think less than two cuts will be appropriate this year doubled from four to eight, while the number of members who believe that more than two cuts will be warranted fell from five down to two. On net, a more hawkish tilt.

During the press conference, Powell acknowledged that tariffs have brought uncertainty to the outlook, particularly as it relates to inflation.  While it is unclear just how tariffs will ultimately be rolled out, for how long, and if/how countries will retaliate, consumers and businesses are already reacting with changes in activity.  The incoming data is showing a weakening economic environment.  For the time being, the Fed plans to wait patiently on the sideline and watch how this all plays out, and the markets will wait for them to signal when it is the next time to move.    

We admit this is an incredibly difficult time to forecast.  The remnants of COVID-era spending measures are still echoing through the system, and how the economy will progress in the short term if true progress is made in cutting the deficits is still to be seen. The era of easy everything is over, and while that may not be a welcome transition for many, it’s a necessary transition. As always, we will continue to watch the data, with an extra emphasis on the money supply as we forecast the path of inflation ahead. We welcome the short-term pain of true change if it leads to the longer-term gains of faster growth and progress on the debt. Let’s hope the Fed is willing to accept that trade-off as well.

Brian S. Wesbury – Chief Economist

Robert Stein, CFA – Deputy Chief Economist

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Implications:  Industrial production rose for a third straight month in February, coming in stronger than expected as a recent “Trump Bump” in activity pushed the index to a new record high.  Businesses can now look forward to an easier regulatory environment in the next four years, as well as lower tax rates on profits.  Yes, manufacturers will now also have to contend with uncertainty surrounding tariffs (whether they are actually put in place or not), and the resulting changes in supply chains.  But, in the meantime, even though President Trump started announcing tariffs in February, the manufacturing sector posted a strong gain of 0.9% for the month.  Looking at the details, auto production jumped 8.5% for the month.  Given the amount of activity that happens in the auto industry across the US southern border, we expect trade negotiations with Mexico to heighten volatility in this sector going forward.  Meanwhile, non-auto manufacturing (which we think of as a “core” version of industrial production) increased a healthy 0.3% in February. This “core” measure has also risen three months in a row and is up at a 6.2% annualized rate over that same period, the fastest three-month pace since the COVID re-opening in 2022.  Another notable gain in this “core” measure came from the production in high-tech equipment which rose 1.4% in February, likely the result of investment in AI as well as the reshoring of semiconductor production.  High-tech manufacturing is up 12.7% in the past year, the fastest pace of any major category.  The mining sector was also a source of strength in February, rising 2.8%.  A faster pace of oil and gas production, metal and mineral extraction, and drilling for new wells all contributed.  Look for an upward trend in activity in this sector in 2025 as the Trump Administration takes a more aggressive stance with permitting.  Finally, the one weak spot in today’s report came from the utilities sector (which is volatile and largely dependent on weather) where activity fell 2.5%.

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Implications:  After unusually cold weather and fires held back homebuilding in January, new home construction rebounded sharply in February, rising to a 1.501 million annual rate and topping even the most optimistic forecast from any economics group surveyed by Bloomberg.  The gain was broad-based with both single-family and multi-family increasing, and three out of four regions contributing. But despite the big jump, starts are still down 2.9% compared to a year ago, while permits for new builds are down 6.8%, and both have been hovering around levels reminiscent of 2019. It appears that part of the reason why homebuilding has lagged of late is due to builders focusing on completing projects.  Home completions declined 4.0% in February, but the 1.592 million annual pace was faster than any month from 2020-2023.  Moreover, completions have run above a 1.5 million pace (our estimation of annual homes needed to keep up with population growth and scrappage) in eleven out of the last twelve months.  With strong completion activity and tepid growth in starts, the total number of homes under construction has declined 14.8% in the past year.  That type of decline is usually associated with a housing bust, but we don’t see that happening.  With the brief exception of COVID, the US has consistently built too few homes almost every year since 2007.  As a result of the shortage of homes, we think housing is far from a bubble and expect housing prices to continue higher in 2025 in spite of some broader economic headwinds.  In other recent housing news, the NAHB Housing Index (a measure of homebuilder sentiment) dropped to 39 in March from 42 in February.  Keep in mind that a reading below 50 signals a greater number of builders view conditions as poor versus good.  On the trade front, import prices rose 0.4% in February while export prices rose 0.1%.  In the past year, import prices are up 2.0% while export prices are up 2.1%.

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Implications:  Retail sales rebounded in February but the details suggest all is not well with the US consumer.  The 0.2% increase in February lagged the consensus expected increase of 0.6%, while last month’s weak reading was revised even lower, now the largest monthly drop excluding the volatile COVID years since 2018.  Moreover, growth was narrow, with more major sales categories (seven) showing declines versus gains (six).  The headline increase was entirely driven by a 2.4% jump in sales at nonstore retailers (think internet and mail-order), possibly the result of front-running goods purchases before tariffs set in.  Strip this category out and overall sales would have declined 0.2% in February.  We like to follow “core” sales, which excludes the often-volatile categories for autos, building materials, and gas.  That measure rose 0.5%, but increased a more modest 0.1% including revisions.  If they stay the same in March, these sales will be unchanged in the first quarter versus the Q4 average; the slowest pace excluding COVID since 2013.  Notably, within this core grouping, consumers pulled back sharply on services in February as sales at restaurants & bars dropped 1.5%, by far the largest decline for any category.  We watch this category closely since it is the only glimpse we get at services in the retail sales report.  These sales (up 1.5% in the past year) peaked in November and have since declined at an 8.5% annualized rate, not a good sign for the overall economy.  As a whole, retail sales are up 3.1% on a year-to-year basis.  However, “real” inflation-adjusted retail sales are up only 0.3% in the past year and are still down from the peak in early 2021.  This highlights the ugly ramifications of inflation: consumers are paying higher prices today but taking home fewer goods than they were more than three years ago.  And while the Fed has cut interest rates a total of 100bps since last Fall, it is not at all clear that inflation problems are behind us.  We hope they have the resolve to stomp out the embers of inflation even if economic troubles come.  In other news this morning, the Empire State Index, which measures manufacturing sentiment in the New York region, declined to -20.0 in March from +5.7 in February.

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Every so often we hear a theory that makes sense superficially but on closer examination doesn’t add up.  The most recent one is that the Trump Administration wants a recession (or at least wouldn’t mind one) because interest rates would drop, making it easier to service the national debt.

We will come back to this theory in a moment, but it seems like this is either misguided thinking, or an attempt to place political blame for long-term problems.

Everyone knows that there has to be a price paid for lousy management.  If you treat your body poorly, say with gluttony or sloth, it may seem fun for a while, but you eventually pay a price.  And rehab is never fun.  Companies that manage themselves poorly are often taken over by better managers who make drastic changes.  Not fun either.  And the government, when it gets out of control, needs to be reined in, too, which can upset the lives of those who let it get that way in the first place.

No one blames the rehab physician or nutritionist for recommending a path back to health, even if they take away the fun.  But for some reason those who come in to fix broken corporations get nicknames like “Chainsaw Al” or “Rambo in Pinstripes.”  Now, Elon Musk may brandish a chainsaw (as a gift from Javier Milei) but doesn’t wear pinstripes, so he gets called other names.

What we are saying is that any budget restraint now being implemented might cause some short-term pain – maybe even a recession – but that doesn’t mean a recession is by design to make the debt easier to service.

To the contrary, a recession would make our fiscal situation worse, not better.  Yes, a recession would likely lead to lower interest rates.  But because the average maturity of government debt is roughly five years, interest payments would only fall gradually.

In the meantime, tax revenue would drop and spending on unemployment insurance and other programs for the jobless and low-income workers would go up faster.  And all of this would be included in any CBO scoring of the budget.  Plus, there’d be increased pressure on Congress to pass temporary measures to fight the recession by expanding the deficit even more, like during COVID.

Even though net interest on the debt has soared, it’s still only about 13% of federal spending.  So even if a recession could temporarily reduce interest, making that 13% easier to service, it would dry up revenue used to finance the other 87% of spending.         

To be clear, we think the Administration is aware that its efforts to cut the government could cause short-term economic pain and they’re not letting that fear deter them.  But that doesn’t mean they’re trying to cause a recession; they’d certainly prefer that the economy keeps growing amid all the spending cuts, because economic growth will help limit debt in the long run.

Brian S. Wesbury – Chief Economist

Robert Stein, CFA – Deputy Chief Economist

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In this week’s “Three on Thursday,” we explore the current state of indebtedness and financial health of U.S. households. Each quarter, the Federal Reserve Bank of New York provides a comprehensive overview of consumer borrowing and repayment trends, drawing from a nationally representative sample of Equifax credit reports. 

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