For the first four trading sessions last week, there was a decided shift away from momentum stocks and away from the perceived AI beneficiaries. That all flipped on Friday after Federal Reserve Chair Jerome Powell spoke on Friday at Jackson Hole and indicated a shift in policy within the Fed. Markets soared, interest rates declined as did the value of the dollar, and Fed Fund futures showed a sharp increase in the probability of a rate cut at the next meeting later in September. In fact, the odds of three rate cuts this year is now a distinct possibility according to futures predictions.
So what changed? Congress has given the Fed a dual mandate. Promote growth and maintain price stability. Before last week, price stability meant getting inflation to 2% through monetary policy, a combination of lower rates and controlling the growth rate of the money supply. By all measures, efforts to bring inflation down to that target have been somewhat successful. Inflation is now below 3% but getting all the way to 2% would be a challenge, especially with the full brunt of tariffs just being felt. At the same time, in order to try and press inflation lower, the Fed has persistently invoked a policy that was restrictive, suggesting lowering inflation was more paramount than stimulating growth.
Actually, the second part of the mandate isn’t specifically targeted at GDP growth but rather at sustaining full employment. Fed policy aside, the single most important economic indicated for nearly a century has been the unemployment rate, a legacy of the scars of the Great Depression. With unemployment persistently close to historic lows, the Fed in recent years has focused on inflation instead. While the sharp inflation of 2022 and 2023 commanded attention, as the pace drifted back below 3%, the necessity to look just at inflation shifted the way the Fed executed policy.
Over the past year or so, the employment picture has shifted. While the unemployment rate has stayed relatively steady, it has masked a significant change in structure. While layoffs have been modest, the number of new hires has slipped as has the size of the workforce, a result of an aging population and less immigration. Thus, today we have fewer workers seeking fewer jobs. The balance may be the same as evidenced by the unemployment rate, but the pace of economic activity is slowing. Over the first half of 2025, the growth rate of final sales, which excludes the impact of trade imbalances and changes in inventories, has barely exceeded 1%. This is far below legitimate targets of 2-3%. While some opine that growth can far exceed 3% with the right set of fiscal and monetary policies, there is little evidence to support such conclusions. Maybe someday AI will lead to a significant and sustained increased in productivity. But so far that is speculation unsupported by any factual evidence.
With that said, a monetary policy that is more stimulative should help, over time, to elevate growth in final sales from barely over 1% at least back to a more normal 2%+. Why only 2%+ and not more? Demographics rule. Without a sustained and measurable increase in productivity, decreased working population growth, which is a function of declining birth rates, aging and a sharp decline in net immigrants, will retard the ability of our economy to sustain growth much more than 2%.
But even so, a policy shift that Powell defined last week should stimulate growth, lead to better real wages, and allow profits to grow. Tariffs remain a headwind, one that should be strongest over the next 6-12 months assuming no further seismic shift in tariff policy, particularly as pertains to Europe, China, Canada and Mexico. But that headwind will be offset by less regulation, some increase in capital spending, and astute corporate management that has already led to double digit earnings increases in the first half of 2025.
Trump promises that the recent tax bill will lead to lower taxes for all. But over 30% of Americans already pay no Federal income tax. The tax benefits clearly aid the wealthier classes. On the other hand, the impact of tariffs will be an added cost to all. In effect, to the extent tariffs are passed through to individuals, they will be a regressive tax. As companies reported second quarter earnings, we have heard repeatedly from managements, the pressures on lower income Americans.
From an investment standpoint, while lower short-term rates will provide some benefit, mostly related to lower credit card costs, the real rate that matters won’t be the Fed Funds rate but rather the 10-year Treasury yield. That will impact government mortgage rates and, to some degree car loans. While that yield fell Friday, it didn’t fall as sharply as short-term rates. Longer-term rates are anchored by long-term inflation expectations. If the Fed says it can tolerate inflation above 2% for a significant period of time, does that mean long-term inflation expectations should rise? The answer is probably yes. So far, 10-year yields have been anchored between 4.1% and 4.6% suggesting some concern about future inflation but little more than normal. However, should fiscal and monetary policy shifts prove too stimulative, there will be a revolt among holders of longer dated bonds and yields will rise. At the moment that is an if, not a prediction. But shifts in both fiscal and monetary policy can have both intended and unintended consequences.
So far, the stock market is applauding. Earnings are rising although the pace of growth will likely moderate a bit as the impact of tariffs becomes fully reflected. It is also worth noting that our economy has gotten a bit lopsided. Growth, both in the economy and in the stock market, has been highly concentrated within AI participants and companies whose businesses support the growth in artificial intelligence, including the surge in data centers and the need for more electric power. I don’t know where this all leads, but history suggests that the real winners will be fewer than equity markets now believe. How many large language models do we need? While there are nuanced differences between them, watching Microsoft#, Meta Platforms#, OpenAI, Google#, Amazon# plus a host of Chinese companies all seeking to be King of the Hill, they won’t all come out on top. Gemini (Google) seems to be the best at video, Anthropic best at coding, ChatGPT at consumer usage. Maybe the leaders will successfully splinter into niches and they can all flourish. But history suggests otherwise. That is not to say that AI isn’t for real. The Internet is clearly for real but early darlings like AOL, Yahoo, MySpace and Global Crossing are long gone or close to gone. I would expect a reckoning within the AI space will take years to evolve leading to both spectacular successes and failures.
Which leads me to one last comment. President Trump wants to acquire 10% of Intel. Without getting into the politics of this, I would only suggest that the Federal government has proven time and again that it is a horrible allocator of capital. Nor is it a particularly good business operator. Think the Post Office, Amtrak or air traffic control. The reason it is so bad is that politics enters into almost every decision. Economics may matter, but not as much as politics. Even when government bailouts allow companies to survive, they don’t make them flourish. Witness the woes of General Motors, for instance, that now requires tariffs to protect its market share and jobs. If Trump successfully gains a share of Intel, it is likely not his last foray into business. The government’s role in business should be one of oversight, not participation.
Today, actress Blake Lively is 38. Celebrity chef Rachael Ray is 57. Director Tim Burton is 67 while singer Elvis Costello turns 71.
James M. Meyer, CFA 610-260-2220