“Let it be, let it be
Let it be, yeah, let it be
Whisper words of wisdom, let it be”
(From “Let it Be” by the Beatles, 1970)
This three-part blog “mini-series” focuses on the Fed – what it looks at and the decisions we think it will make as we move through 2026 and into 2027. In Parts I and II we focused on the primary Fed mandates – the labor market and inflation. Here in Part III, we focus on the economy – not officially part of the Fed’s mandate but something we know it watches very closely.
By Scott Welch, CIMA®, CEPA®, Chief Investment Officer & Partner
Reviewed by Carter Mecham, CMA®, IACCP®
In Parts I and 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.
As we approach the end of Q2, we see that the first half of the year enjoyed mostly positive economic conditions. We happen to believe that, because of our relative energy independence, the US has not felt the full economic impact of the Iranian conflict. There may be a lagged negative effect as we move through the summer, but we are not seeing any serious issues at the present time.
We further believe that the mania surrounding Artificial Intelligence (AI) and the corresponding massive capital expenditures regarding data centers, chip production, and energy production and transmission have “propped up” the economy beyond its underlying fundamental condition.
Don’t get us wrong – growth is growth and we believe in the potential of AI as much as anyone.
But let’s dive a little deeper beyond the headline numbers and see if we can get an even more clear picture of the state of the economy.
GDP Growth
The second estimate for Q1 GDP growth revised the initial estimate downward from 2.0% to 1.6%. Still positive but hardly robust, and that was before the Iranian war began.
The most recent Atlanta Fed “GDPNow” estimate for Q2 GDP growth is a positive 3.0%. This would be a great number if it turns out that way, but we suspect that forecast will decline slightly as we move toward the end of the quarter.
Source: The Atlanta Fed, as of June 1, 2026. This is an estimate and therefore subject to change as additional come in.
Both the New York Fed at 2.5% (first chart) and the St. Louis Fed at 1.6% (second chart) are projecting lower growth than the Atlanta Fed.
Source: The New York Fed, as of May 29, 2026. This is an estimate and therefore subject to change as additional come in.
Source: The St. Louis Fed (FRED), 5-year data as of June 5, 2026. This is an estimate and therefore subject to change as additional data come in.
We believe actual GDP growth will come in somewhere between 2.0%-2.5%, and this is aligned with the median consensus forecast from a variety of sources.
Source: Capital Spectator, as of June 3, 2026. These are estimates and subject to change as additional 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 upward and solidly in expansionary mode – a positive sign for the economy. Keep in mind that the US economy is roughly 70% services-oriented (manufacturing is only approximately 9%), so this metric is the one that represents the closest proxy to the overall economy.
Source: The ISM and dShort.com, through May 2026. Past performance is no guarantee of future results.
Consumption
What about the consumer? Remember that consumption drives roughly 70% of US GDP – we are decades past being primarily a manufacturing society.
Let’s start with retail sales. Through the end of April, nominal retail sales showed continued growth, but once inflation is factored out (i.e., real retail sales), we see a relatively flat line of retail sales for most of the past five years. Consumers are still buying but are not increasing their real level of consumption.
Source: The St. Louis Fed (FRED), 5-year data through April 2026. Past performance is no guarantee of future results.
Two other aspects of consumption are worth noting. First, while consumption remains the primary driver of the US economy, in Q1 it was actually capital expenditures (driven by massive AI-oriented spending) that was the larger percentage of Q1 growth.
Source: The Daily Shot, as of May 1, 2026.
The second thing to note is how consumers are paying for their purchases. People have long since worked their way through any Covid-related savings they may have accumulated and are now increasing their use of credit cards to finance consumption.
With the average credit card interest rate exceeding 25% annually, this means of financing consumption is unsustainable. A day of reckoning is coming.
Source: St. Louis Fed (FRED), 12-monthdata through April-May 2026.
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 May 2026, we see a very interesting phenomenon. The economy is chugging along, and the stock market is going gangbusters.
But people are as unhappy as they’ve been in a long time.
Source: Conference Board, University of Michigan, and dShort.com, through May 2026.
What is going on? We think the simple answer is inflation, especially with respect to food and energy prices. We discussed this in Part II of this series, but the bottom line is that people are finding it hard to keep up with price increases in the things they consume the most.
Another source of potential discontent is the AI phenomenon itself. It is far too early to tell how things will turn out, but an increasing number of workers are either concerned about losing their jobs to AI or robots or, in the case of many new college graduates, finding it difficult to secure an entry level position in their chosen career (e.g., finance or law).
One final point of potential discontent is the so-called “K-shaped economy.” While overall consumption is increasing (at least in nominal terms), that consumption is concentrated within the “high earning” subset of the economy. Lower wage earners are not keeping up.
Source: Bureau of Labor Statistics and the Opportunity Insights Economic Tracker, data from January 2020 – June 2024 (dashed lines represent projections for 2025-2026).
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 6-9 months or so is an initial “Trump Bump” in optimism after the November 2024 election, followed by a steady decline since January of this year.
Source: The NFIB and dShort.com, data through April 2026.
There are multiple primary drivers of this general sense of pessimism:
- Perceived low quality of available labor
- Fear of inflation, especially in light of the Iranian conflict
- Weakening sales trends
- Operating margins under pressure
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 May, we see the economy acting essentially the way economists anticipated. The trend line is upward, indicating slightly better actual versus forecasted data but, for now, the economy seems to be just maintaining its non-recessionary path.
Source: Citigroup and Yardeni Research, through June 4, 2026. 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 the labor market, inflation, and now the general state of the US economy.
Our conclusions? We stand by our belief that the Fed will take no action in its June or July meetings, will come out after the June meeting with meeting minutes that indicate a shift toward a “tightening” bias, and perhaps with a rate hike in September (assuming inflation remains problematic). If it does hike rates, it will cite inflation as the catalyst for the move.
The Fed Fund futures trading market seems to agree with us.
Source: The Atlanta Fed “Market Probability Tracker,” as of June 4, 2026. These are estimates and subject to change as additional data come in.
We do not envy Kevin Warsh his new job – he is walking into a difficult situation. When he was nominated by President Trump, many people believed that nomination came with an implicit assumption that Warsh would argue for the lower rates that President Trumps claims he wants. We never really believed that assumption – Mr. Warsh’s history with the Fed argued against it.
In any event, the underlying conditions he is walking into are quite different from the one in place when he was nominated, and we don’t believe we’ve yet seen the longer-term effects of the Iranian conflict and corresponding closing of the Strait of Hormuz, through which an enormous percentage of global oil, liquified natural gas, urea (fertilizer), helium, and other key industrial commodities pass.
The longer the conflict goes on the bigger the potential impact on global inflation and economic growth.
We believe the Fed should be – as it claims to be – both independent and “data dependent.” And we believe Chair Warsh will maintain that independence and try to lead the Fed to where the data point to.
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.
We hope you find this helpful and, as always, we welcome your feedback and questions.