Economic Commentary – The Goldilocks Decision

We all remember the Goldilocks story in which our main character stumbled upon the bears’ home and searched for the porridge, chair, and bed, which were “just right.” That is an appropriate metaphor for our current macroeconomic environment. The Fed especially is struggling to make its next interest rate move “just right.”

What Does The Bigger Picture Look Like?

The backdrop for the Fed’s concern about how to dial in just the right interest rate change can be seen in a couple of recent economic reports:

The most recent GDP report provided a solid headline: Real economic growth hit a 3% annual rate in the 2nd quarter. This was well ahead of the consensus, and represented a significant improvement from the first quarter’s 0.5% decline in real GDP. Swings of 3.5% over the course of one quarter like this are not normal, but they are also not unheard of. Some commentators are pushing this as evidence that the economy is roaring, while others are arguing it’s a nothing-burger. Political motivations are rampant on both sides; the reality is squarely in the middle. 

The Trump administration’s most recent budget bill (literally named the “One Big Beautiful Bill Act” or OBBA for short) has codified several economic growth-inducing policies. At the same time, the administration’s use of tariffs potentially hampers economic growth. Accordingly, we don’t believe the sharp uptick in economic growth in the 2nd quarter was evidence of a massive economic growth wave. Rather, it was a reflection of how various businesses have reacted to the administration’s handling of tariffs. 

When President Trump announced his intentions of slapping massive tariffs on various trading partners, US producers reacted by expediting their purchases of foreign-made products to get in under the wire. Since imports are technically included in GDP calculations as a subtraction from economic growth, Q1’s economic numbers were massively depressed.

In the 2nd quarter, as tariffs actually kicked in, US producers switched back to placing orders with domestic suppliers, thus inflating Q2 GDP calculations. The net result was a lot of economic statistical volatility, but a more modest net impact overall.

If we combine both the 1st and 2nd quarters, real GDP grew at a very modest 1.5% annual rate. This is well below the long-term trend of a 2% per year average of the last twenty-plus years. While we’re still growing economically, this is not the makings of a substantial boom at this time; the jury is still out.

Likewise, the jury has not yet spoken on whether we will have a recession in the near term. Conflicting indicators point us back to the Federal Reserve and the decisions it will make over the course of the back half of this year. Their actions in the next several months will likely determine whether modest growth continues, growth accelerates, or we slip into a mild recession.

In short, the Fed is following a Goldilocks path of trying to keep inflation low without cratering the economy. As many economists have noted, “a monetary policy tight enough to reduce inflation may also be tight enough to induce a recession.” The Fed needs to get this “just right.”

Inflation Fades From Center Stage

One of the other recent economic reports we referenced chronicled the Consumer Price Index for July. As expected, the CPI rose roughly 0.2% for the month, with the year-to-year (July to July) rate coming in at 2.7%. “Core” prices, which exclude food and energy, increased 0.3% in July, putting the twelve-month inflation rate at 3.1%. While both these measures (CPI and “core” CPI) are higher than the Fed’s 2% annual goal, focusing on the last several months provides a better sense of trajectory for the future. Over the last six months, which includes higher tariffs, prices have only increased at a 1.9% annualized rate, with core inflation hitting a very reasonable 2.4%.

We reference tariffs in the discussion of the last 6 months’ inflation data because there is a widespread misunderstanding of the role tariffs play in inflation. Many commentators across the spectrum assume that tariffs cause inflation. This couldn’t be further from the truth. Tariffs can have a significant negative impact on overall economic growth, but they cannot cause inflation.

The prices for tariffed products clearly increased. But that increase leaves less money for producers or consumers to spend on non-tariffed items. Inflation is an increase in the “overall price” level, not the price of some products. Inflation is caused by mismanagement of the money supply. As the Nobel laureate Milton Friedman proved decades ago in his seminal research on this topic, “inflation is always and everywhere a monetary phenomenon.”

In the immediate aftermath of the Covid lockdowns, the Fed expanded the country’s money supply at unprecedented levels. This did not immediately impact the inflation level because the lockdowns actually created an unprecedented demand for money. In other words, the demand for money and the supply of money both increased. The net effect was not inflationary. That started to change – and then changed dramatically – as we came out of the lockdowns, confidence returned, and the demand for money decreased. Fewer people felt the need to “keep money” in their bank accounts, and they started spending it. As this pivot in demand occurred, the money supply remained unchanged. This is when the inflationary effect of the Fed’s action kicked in. The supply remained high even as demand plummeted; inflation hit hard. The cumulative inflation rate since the Covid lockdowns stands at approximately 25% (2020 through 2025 to date).

In response, the Fed increased interest rates to tame inflation with 11 rate hikes in a two-year period, representing the most significant rate hikes since the 1980s. Arguably, the Fed was very late to the recognition of inflation’s strength, initially commenting that inflation appeared only “transitory” before abruptly about-facing with a public statement of concern about inflation’s impact. 

Clearly, progress has been made as evidenced in the CPI numbers discussed above – especially those of the last 6 months. Today, the concern is that the Fed may be late in recognizing the progress it’s made and, therefore, might keep rates too high for too long. This is the crux of the Goldilocks decision they have to make. In the months ahead, will they maintain current rates, decrease them slightly, or decrease them significantly? If they do decrease, how many rate cuts would this represent over what time period?

Chairman Powell is famous for highlighting different metrics at different times. This creates uncertainty in the market; everyone knows that interest rates affect the economy, if only because interest rates affect long-term decisions about capital investments in plant and equipment. At times, Powell has emphasized the CPI, at other times “core” CPI, and at other times still “super core,” only to return to commenting on regular CPI.

We believe the Fed will cut rates in its September meeting, but we long ago gave up on any claims that our crystal ball has superpowers. In the last Fed meeting, Chairman Powell convinced the board to keep interest rates unchanged, but not without significant defections. Fed minutes show two Fed governors dissenting from this decision in favor of reducing rates then. One needs to understand the normally collegial nature of the Federal Reserve Board Governors to understand the significance of this split. This is the first time dissent has been noted in the minutes since the early 1990s.

Other Economic Signals

Against this backdrop and uncertainty, we see other economic reports pointing toward slowness, with others pointing toward growth, perhaps even significant growth. Both the ISM Services report and the ISM Manufacturing report seem to indicate a slowing economy. Having said that, both these reports reflect sentiment as well as actual economic activity. On the other hand, for Q2, 81% of the S&P 500 companies have reported positive earnings per share (EPS) surprises (meaning better than expectations). This brings the annual earnings growth to 11.8%, an impressive number.

Where Will Goldilocks Sit?

What will the Fed decide to do? How will the market react? How will the market anticipate what the Fed will do?, etc. The list of questions, no matter how they are phrased, all point back to the Fed. To some extent, this is unfair since tariffs, if implemented at an extreme level, could easily derail the economy, but these seem unlikely at this time. 

We have previously noted that the tariff issue hinges on whether tariffs are a policy goal in their own right (bad for the economy) or merely negotiating tools to secure better trade deals worldwide (good for the economy). With 6 months under our belt, the evidence seems to point toward them simply being negotiation tools.

That puts the Fed front and center. One advantage the economy and markets have at this particular time is the calendar date. Powell’s term as head of the Fed ends in early 2026. As objective and independent as the Fed was established to be, it still remains a political institution subject to political considerations. That is not necessarily a bad thing; it keeps the Fed governors from becoming too imperious and believing that they can simply do as they wish. They keep an eye on the economy even as they keep an eye on their job.

If the Fed chooses wisely, we can all celebrate. If it stumbles in the months ahead, corrective action would be taken under the direction of a new Fed Chairman.

Should We Base Our Decisions On What Goldilocks Does?

Determining what to do with an investment portfolio is dependent on your timeframe. But that has always been the case, and herein lies a paradox.