“You can’t hurry love
No, you’ll just have to wait
Just trust in a good time
No matter how long it takes“
(Written by Holland-Dozier-Holland, 1966, originally performed by the Supremes and covered by Phil Collins))
By Scott Welch, CIMA®, Chief Investment Officer & Partner
Reviewed by Carter Mecham, CMA®, IACCP®
In Part I and Part II of this “mini-series,” we focused on the Fed’s primary mandates –inflation and the labor market. In this final “episode,” we focus on the economy – which is not officially part of the Fed’s mandate, but something it watches very closely when determining its rate policy.
GDP Growth
As Q3 begins, we see that the first half of the year had its ups and downs but was still positive overall. While the current estimate for Q1 GDP growth is a negative 0.5%, the current Atlanta Fed “GDPNow” estimate for Q2 GDP growth is a positive 2.5%. While not overly robust, there still does not appear to be a recession in the near future.
Source: The Atlanta Fed, as of July 1, 2025. This is an estimate and therefore subject to change as more data come in.
Both the New York Fed and the St. Louis Fed are projecting lower growth than the Atlanta Fed. The St. Louis Fed is forecasting barely positive growth for Q2.
Source: The Atlanta Fed, as of July 1, 2025. This is an estimate and therefore subject to change as more data come in.
Source: The St. Louis Fed, as of June 30, 2025. This is an estimate and therefore subject to change as more data come in.
Manufacturing and Services
Now let’s look at the manufacturing and services sectors, as measured by the Institute for Supply Management (ISM). Based on the metrics it evaluates, a reading above 50 indicates an expanding economy, while a reading below 50 indicates a contracting economy.
Through the end of May, both the manufacturing and services sectors were trending downward and in “contraction” territory, indicating a definite slowing of the economy.
The June manufacturing index came in at 49, a slight increase from the May level but still in contractionary territory. It marked the fourth straight month of contraction, where it has been for 30 of the past 32 months.
Source: The ISM and Ycharts, through June 2025. Past performance is no guarantee of future results.
Consumption
What about the consumer? Remember that consumption drives roughly 60-70% of US GDP – we are decades past being primarily a manufacturing society.
Let’s start with retail sales. Through the end of May, nominal retail sales showed continued growth, but once inflation is factored out (i.e., real retail sales), we see a minimal increase. Consumers are still buying but seem to be slowing down.
Source: The St. Louis Fed (FRED), 10-year data through May 2025. Past performance is no guarantee of future results.
Sentiment
How about consumer and small business owner “sentiment” – how are they “feeling” about the current and future state of the economy?
Consumer Sentiment
We’ll start with the consumer indexes. The two most widely followed are the Conference Board Consumer Confidence Index (CCI) and the University of Michigan Consumer Sentiment Index (MSCI). Though both are based on consumer surveys (i.e., “soft” data), each uses different evaluation techniques. But combined they provide useful insights into how consumers are “feeling” about the state of the economy.
Through June 2025, we see that sentiment is not overly negative by historical standards, but with both indices we see a general downward trend. We ascribe that to uncertainty regarding taxes, tariffs, the budget, and geopolitical tensions. In other words, consumers seem to feel okay about their future economic state but are growing more uncertain about policy and political issues.
What is difficult to evaluate is how much of this uncertainty is media-driven. The mainstream media is decidedly “anti-Trump” and so generally positions anything he does or says in a negative light.
But when the actual impacts of his tariff, tax, and geopolitical policies are evaluated, they simply have not been that dramatic. Perhaps they will be eventually, and this is one of the main reasons the Fed is cautious about cutting rates, but any negative effects simply have not shown up yet in the hard data (i.e., actual numbers versus sentiment).
Source: dShort.com, data through June 2025. Past performance is no guarantee of future results.
Small Business Owner Sentiment
Small business owners (defined by the Bureau of Labor Statistics as firms with less than 100 employees) drive roughly 40-50% of all US GDP, so their sentiment matters greatly in terms of hiring, prices, and general outlook on the economy.
The National Federation of Independent Businesses (NFIB) is an advocacy organization for small businesses. They produce a monthly survey illustrating how small business owners are feeling about the economy, taxes, future hiring plans, and other metrics.
What we see over the past six months or so is an initial “Trump Bump” in optimism after the November election, followed by a general decline as reality set in, reaching its nadir following the “Liberation Day” tariff announcements in early April. As those tariffs were renegotiated or put on hold, optimism has crept back in.
The final agreement to the budget bill will probably have a significant effect on small business owner optimism as they figure out the future tax and policy regimes.
Source: The NFIB and dShort.com, data through May 2025. Past performance is no guarantee of future results.
Expectations vs Reality
While there is plenty of economic data available to examine, let’s look at one last metric – the Citigroup Economic Surprise Index. This index compares the actual economic data that come in versus the forecasted estimates that are announced beforehand.
This index tends to “mean revert” over time, so while the actual level of the index is relevant, we prefer to focus on the trend. If the index is going up, it means that the actual data are coming in more positively than the forecasts. Conversely, if the index is trending downward, it means the actual data are coming in weaker than forecasted.
Through the end of June, we see the economy acting essentially the way economists anticipated. The trend line is slightly upward, indicating slightly better than forecasted data but, for now, the economy seems to be just maintaining its non-recessionary path.
Source: Citigroup and Yardeni Research, through June 30, 2025. Past performance is no guarantee of future results.
Summary and Conclusions
This is the final “episode” in our three-part “mini-series” on “What Drives the Fed.” We’ve examined inflation, the labor market, and now, the general state of the US economy.
Our conclusions? There do not seem to be much hard data to suggest the Fed needs to be overly aggressive in cutting rates. The market is pricing in some possibility of a July rate cut, but a much higher probability of a September cut, and we agree.
Source: The Atlanta Fed “Market Probability Tracker,” as of June 30, 2025. These are estimates and subject to change as additional data come in.
Since inflation remains stubbornly above the Fed’s target rate of 2% annualized, we suspect that if the Fed does cut rates in September, it will indicate that the catalysts for that rate cut are a softening labor market and a cooling economy.
As we mentioned in Part II of this mini-series, we remind you that it was a cooling of the labor market back in August 2024 that prompted the Fed to cut rates by a surprising 50 basis points (0.5%). We did not agree with that decision – we thought it was unwarranted, and it ultimately proved to be inflationary.
But unless the data come in surprisingly strong between now and September, we believe the Fed will cut rates by 25 basis points (0.25%) at that time. President Trump is strident in his criticism of both Chair Powell and the FOMC overall – he thinks rates should be 1% or lower.
We respectfully disagree. The one thing we do believe in strongly is that the Fed should not be subjected to political pressure from the President or anyone else.
As “Exhibit A” in our argument, we refer readers to what happened when Fed Chair Arthur Burns lowered rates back in the late 1960s under pressure from President Richard Nixon, who wanted to stimulate the economy ahead of his reelection campaign in 1972. That, combined with the Middle East oil embargo of the mid 1970s, led to massive inflation that took almost ten years to address (and only when Fed Chair Paul Volker raised the Fed Funds rate to 20% to combat inflation).
We are not suggesting there is much risk of a repeat of the 1970s. For one thing, we are not as dependent on Middle East oil as we used to be as we have achieved “energy independence.”
This partially explains why the US markets barely reacted to the Israeli/US bombing of Iran and the subsequent threat by Iran to shut down the Strait of Hormuz, through which roughly 20% of the global oil supply passes.
Further, Fed Chair Powell has remained steadfast in the face of President Trump’s rhetoric. When his term ends in 2026, we have little doubt that Trump will replace him with a more “dovish” Chair, but we are not there yet.
We believe the Fed should be – as it claims to be – both independent and “data dependent.” In any event, from an investment perspective, we repeat what we suggested in both Parts I and II:
We continue to recommend diversification at both the asset class and risk factor levels, maintaining portfolio discipline, and maintaining a longer-term time horizon.
Focus on the signals, not the noise.
There are clouds on the horizon, but we see no particular need to panic barring an unexpected domestic or international political event (e.g., Congress does not pass a budget and debt ceiling bill or Iran actually does move to retaliate against the US and Israel and is backed by China – which consumes roughly 90% of Iran’s otherwise-sanctioned oil production).
We hope you find this helpful and, as always, we welcome your feedback and questions.