A Changing Policy Backdrop Could Test Market Optimism

Brent Schutte, CFA, is chief investment officer of the Northwestern Mutual Wealth Management Company.

In a week that saw NVIDIA, the largest company in the world, report strong earnings that sent its stock sharply higher and reinvigorated optimism in the artificial intelligence (AI) trade, fiscal and monetary policymakers continued to provide the biggest headlines. This was especially true on Friday, when Federal Reserve Chair Kevin Warsh took the stage at the Federal Reserve Bank of Kansas City’s annual Jackson Hole Economic Policy Symposium and provided insight into both the principles he believes should guide the monetary policy framework and his much-awaited assessment of the current U.S. economy. Taken together, these developments help frame the investor question we believe matters most: how the economy and markets transition from a post-Great Financial Crisis (GFC) era defined by aggressive monetary and fiscal support to one in which both policy levers may be more constrained, and what that means nearer term for growth, inflation, rates and market leadership.

Long Term

The post-GFC era, from 2009 until today, has been marked by a seemingly never-ending expansion of monetary and fiscal policy “intervention” as policymakers attempted to revive a badly bruised U.S. and global economy, one that Chair Warsh reminded us was widely believed to be in a period of secular stagnation. After pushing rates to zero, the Federal Reserve (Fed) repeatedly embarked on large-scale bond purchases that expanded its balance sheet, commonly known as quantitative easing, while also providing forward guidance on its potential future actions. In many ways, both tools were designed to compel investors and economic actors to take risk and pull the stagnant economy higher.

On the other side of the equation, fiscal policymakers, on a bipartisan basis, continued to provide a healthy amount of stimulus to the economy. The result has been a continued increase in U.S. debt held by the public to roughly $32 trillion, or about 100 percent of GDP, the highest level since the end of World War II. The cost of this aggressive monetary and fiscal policy mix appeared minimal for much of the period because the Fed was trying to push inflation up to its 2 percent target while the interest cost on Treasury debt was moving lower, keeping annual interest expenses contained.

Those two realities likely helped contribute to the incredibly strong run in equity markets, during which nearly every economic threat, including COVID, proved remarkably short-lived given the large amount of stimulus that was deployed in response to almost every problem. This shaped our outlook during that period. We certainly believed the economy and markets could experience hiccups, but we also believed those disruptions would likely be short because of the sheer amount of stimulus policymakers were willing to throw at any meaningful pullback. Longer-term followers will recognize this discussion from our COVID-era outlooks, when we expressed our optimism that equity markets would snap back quickly as policymakers unleashed an extraordinary amount of stimulus to bridge the economy through the shutdown.

This is where last week’s fiscal and monetary policy pronouncements may herald a meaningful shift for investors to contemplate. Early last week brought additional information on the potential for the U.S. Treasury to intervene in bond markets in an attempt to pull down yields. On Monday, CNBC reported that two senior Treasury officials said the Treasury could use its nearly $1 trillion Treasury General Account to help fund longer-term Treasury buybacks, thus increasing the “firepower” to pull yields lower from the original $4 billion commitment. While much of the discussion focused on whether this would work, we believe the more important question is why it is being considered.

This is where rising Treasury debt is now being met with higher interest costs. Consider that the average interest rate on outstanding U.S. Treasury debt is 3.44 percent, up from the recent low of 1.42 percent in January 2022 and the highest level since September 2008, just before the GFC ushered in a period of heightened debt growth. This has pushed annual net interest expense on U.S. Treasurys to more than $1 trillion, an amount now larger than what we spend on defense. It represents 3.1 percent of annual U.S. economic output, placing it in a near dead heat with 1991 as the highest level in data going back to 1940. Complicating the future reality is that the entire U.S. Treasury yield curve now ranges from roughly 3.7 percent to 5.2 percent on the 30-year Treasury. Simply put, each additional dollar of debt now increases U.S. interest costs. This helps explain the administration’s desire for lower yields and the broader effort we discussed in last week’s commentary to create additional demand for Treasurys, including through stablecoin legislation and actions tied to foreign Treasury demand.

Warsh’s comments fit squarely into this same broader transition. He has spent much of his recent past highlighting concerns about the Fed’s repeated use of quantitative easing, and he used much of his Jackson Hole speech to sharpen his critique of forward guidance. Indeed, he committed to ending forward guidance, which he noted was adopted by him and his colleagues during the GFC and was “essential then” but which he now believes has overstayed its welcome. Most notably, he stated, “Markets should form their own expectations of output, employment, and inflation and stay sharply attuned to risks.” That is a meaningful shift from the post-GFC framework and one that investors should not dismiss. Quantitative easing and forward guidance were designed, at least in part, to lower perceived risk, encourage investors and economic actors to take more risk, and use stronger asset prices and easier financial conditions to help pull the broader economy higher. Importantly, he discussed not only how forward guidance can limit the Fed’s ability to move, highlighting the slow response to inflation in 2021 as an example, but also what he called a “hall of mirrors” problem. In his view, forward guidance can create blindness and unpreparedness for future events, raising the likelihood of policy errors. As he noted, “The most serious harm is likely to befall those without financial assets.” Put differently, if the Fed gets inflation wrong, it is not financial high fliers who bear the greatest burden. It is hardworking Americans who are left to deal with inflation that is too high or jobs that suddenly appear less secure.

This is why we believe the secular backdrop is changing. The good news is that artificial intelligence (AI) is pushing growth higher and creating the potential for meaningful productivity gains over time. The bad news is that both monetary and fiscal policymakers may be less able—or in some cases, less willing—to provide the same level of stimulus to the U.S. economy in the future. While we remain optimistic about both the U.S. economy and markets over the long term, the reality is that forward equity returns may be lower and economic and market hiccups may last longer than investors have become accustomed to. Put simply, we believe buying dips remains a viable long-term strategy, but the gratification from doing so may be less immediate.

Near Term

The economic data last week confirmed much of what the Chair discussed: a strengthening economy supported by healthy AI capital investment that has remained resilient despite repeated shocks, alongside a stable labor market that appears to be meeting the Fed’s mandate of maximum employment. That backdrop matters because Warsh made clear that the Fed remains committed to returning inflation to target. While many have wondered which inflation measure the Fed may emphasize, he stated, “The Fed’s price-stability objective of 2 percent, as measured by the personal consumption expenditures (PCE) price index, is a firm, fixed target.” Recent inflation data did little to change that view. PCE inflation checked in at 3.7 percent year over year for July, with the six-month annualized pace at 4.1 percent. He also noted, “While this summer’s PCE and Consumer Price Index (CPI) readings were better than expected, they do not tell me that underlying trends have meaningfully improved,” and he reminded listeners that inflation has been above the Fed’s 2 percent target for 65 straight months.

Just as important, Warsh said he would be “hard pressed to describe broad financial conditions as restrictive.” Taken together, above-target inflation, resilient growth, and financial conditions that are not clearly restrictive help explain why markets increased the odds of additional tightening. The result was an uptick in rate hike expectations, with markets pricing in a 57 percent chance of a 25-basis-point increase at the September meeting, up from 36 percent, while also adding another 25-basis-point hike by March.

This brings us full circle. We have long stated that AI has become more interest-rate sensitive given the large amount of debt and equity capital needed to bring it to life. Unlike earlier stages of the technology cycle, when investment could be funded largely from free cash flow, the current buildout may be more exposed to future rate increases. This reality raises risks to both the AI story and the broader U.S. economy if the Fed is forced to embark on a series of rate hikes to quell sticky inflation.

But the investor risk is not just about interest rates. It is also about where the value from AI ultimately accrues. Warsh’s comments on AI rhyme with our plea for investors not to become overconcentrated or overconfident in any one stock, sector, or theme. As we have expressed, we believe AI will have far-reaching implications and benefits for the U.S. economy, albeit with many unknowns or, as Warsh stated, “major lines of inquiry.” Most important, and consistent with our recent comments, was this passage:

“Among the other yet unknowns is the resulting market structure. It's not obvious where the returns on capital will land or on what timescale. Early on, how much of the surplus goes to owners of scarce assets, AI labs, chipmakers, energy producers, and cloud providers? Over time, how much of that value accrues to businesses and consumers?”

That uncertainty is central to our point. Much of the surplus has so far gone to the labs, chipmakers, and other companies bringing AI to life. Over time, that value may begin transferring to the broader economy and to the companies that use AI most effectively.

That is why we continue to urge diversification rather than concentration given the uncertainty around where AI moves next. Much like prior innovations, today’s winners could become tomorrow’s losers, and value will continue to shift across the economy and markets. Stay focused on the intermediate to long term, stay invested, and remain true to the allocation dictated by your financial plan.

Wall Street wrap

Inflation remains stuck above the Fed’s target

Last week’s economic data reinforced a theme we’ve highlighted for several months: The U.S. economy remains resilient, but inflation also remains stubbornly above the Fed’s target.

The Bureau of Economic Analysis reported that the Personal Consumption Expenditures (PCE) price index, the Fed’s preferred inflation gauge, rose 0.2 percent in July and is now up 3.7 percent from a year ago. Core PCE, which excludes food and energy, increased 0.25 percent during the month and is now up 3.3 percent year over year. Importantly, progress on underlying inflation remains limited. Core inflation is running at a 3 percent annualized pace over the past three months, 3.5 percent over the past six months, and 3.6 percent over the past nine months, suggesting inflation remains stuck well above the Fed’s 2 percent target.

A closer look reveals a mixed picture. Core goods prices fell 0.11 percent in July but remain up 3.7 percent from a year ago, with the six-month annualized pace slowing to 3 percent. Meanwhile, services prices rose 0.27 percent and are also up 3.7 percent year over year. Supercore services inflation, which excludes shelter and is often viewed as a measure of underlying services inflation, rose 0.29 percent in July. On an annualized basis, the category is running at 4.16 percent over the past three months, 3.65 percent over the past six months, and 3.98 percent over the past nine months.

One important caveat is that portfolio management fees are included within the supercore measure, and financial services accounted for roughly half of July’s increase in core inflation. This matters because the Bureau of Economic Analysis is scheduled to implement benchmark revisions in mid-September that are intended to improve how it measures certain services categories, including portfolio management, legal services, and software prices. According to market research firm Piper Sandler, these changes could reduce the current year-over-year core inflation reading by roughly 0.3 percentage points, bringing core inflation closer to 3 percent. While that would be an improvement, inflation would still remain above the Fed’s target.

Consumers feel good about today but worry about tomorrow

Consumer sentiment data painted a similarly mixed picture. The Conference Board’s Consumer Confidence Index slipped to 89.4 in August from 90.2 in July. However, beneath the headline decline were signs that consumers continue to view current labor market conditions favorably. The present situation index rose to 121.2 from 114.4, while the share of consumers saying jobs are plentiful increased sharply to 27 percent from 24.4 percent. At the same time, the percentage saying jobs are hard to get fell to 19.5 percent from 21.7 percent. As a result, the labor differential improved from a revised 2.7 to 7.5, matching its highest level of the year.

The outlook for the future was less encouraging. The expectations index fell to 68.2 from 74. Consumers became more pessimistic about employment prospects, with those expecting more jobs declining to 14.6 percent from 16.4 percent and those expecting fewer jobs increasing to 26 percent from 25.3 percent. Income expectations also deteriorated. The share of consumers expecting higher income fell to 17.6 percent from 19.5 percent, while those expecting lower income rose to 13.8 percent from 12.6 percent. As a result, the income differential dropped to 3.8 from 6.9, its weakest reading since March and April of 2025 (around "Liberation Day") and, before that, April 2024. Inflation expectations also moved higher, rising to 5.8 percent from 5.6 percent. Buying plans for homes, automobiles, and major appliances all declined during the month.

Housing inventory continues to rise as new home sales weaken

Housing data also reflected some softness. New home sales fell 10.5 percent in July to an annualized pace of 607,000 units, the weakest reading since January. However, June sales were revised sharply higher to 678,000 from the previously reported 628,000. Inventory continued to build, rising to 488,000 homes from 479,000, leaving supply at 9.6 months at the current sales pace. The median new home price came in at $393,800, with a larger share of homes selling below $400,000.

Consumers continue spending faster than income is growing

Finally, consumer spending continued to advance, albeit at a modest pace. Personal income rose 0.4 percent in July and is now up 3.7 percent from a year ago, while wages and salaries increased 0.3 percent during the month and are up 3.5 percent year over year.

Disposable personal income increased 0.5 percent in July and is now up 4.2 percent from a year ago. After adjusting for inflation, real disposable personal income rose 0.4 percent during the month but is up just 0.5 percent year over year. Excluding transfer payments, disposable personal income is down 0.4 percent from a year ago and has been either negative or near zero on a year-over-year basis since March 2026.

Personal spending rose 0.2 percent in July, while real spending was unchanged during the month and is up 2.1 percent from a year ago. Overall personal spending is up 5.9 percent year over year, while disposable personal income is up 4.2 percent. In other words, consumers continue to spend faster than their incomes are growing. The result has been a declining savings rate, which fell to 3 percent from 4.5 percent a year ago. While spending remains supportive of economic growth, consumers appear increasingly reliant on drawing down savings to maintain that pace.

The week ahead

Tuesday: The Institute for Supply Management will release its August Manufacturing Purchasing Managers’ Index at 10:00 a.m. ET. We will be watching whether the factory sector continues to expand after July’s strong reading and whether new orders, employment, and prices paid point to continued resilience or renewed pressure from tariffs and elevated input costs. The Bureau of Labor Statistics will also release July Job Openings and Labor Turnover Survey data at 10:00 a.m. ET, which should provide additional insight into labor demand and whether the jobs market is continuing to cool.

Wednesday: ADP will release its August Employment Report at 8:15 a.m. ET, offering an early look at private-sector hiring ahead of Friday’s employment report. The Census Bureau will also release July Durable Goods Orders at 8:30 a.m. ET, followed by July Factory Orders at 10:00 a.m. ET. We will be focused on whether demand for big-ticket manufactured goods and broader factory orders suggest business investment is holding up despite higher interest rates and lingering uncertainty.

Thursday: The Department of Labor will release its weekly Initial Jobless Claims report at 8:30 a.m. ET. We will be monitoring whether claims remain consistent with a still -solid labor market or begin to show signs of a more meaningful slowdown. Also at 8:30 a.m. ET, the government will release July trade data and revised second-quarter productivity and unit labor cost figures, which could provide insight into the inflation backdrop and the degree to which productivity gains are helping offset wage pressures. The Institute for Supply Management will release its August Services Purchasing Managers’ Index at 10:00 a.m. ET, a key read on the largest part of the economy.

Friday: The Bureau of Labor Statistics will release the August Employment Situation report at 8:30 a.m. ET. We will be focused on nonfarm payroll growth, the unemployment rate, average hourly earnings, and the labor force participation rate for clues about whether the labor market is cooling gradually or losing momentum more quickly. Because labor market trends remain central to the outlook for consumer spending, inflation, and Federal Reserve policy, this report is likely to be the week’s most closely watched release.

Frequently Asked Questions

Why could the policy backdrop be changing for investors?

For much of the post-Great Financial Crisis era, markets benefited from aggressive monetary and fiscal support. The article argues that higher debt costs, persistent inflation, and a Federal Reserve more focused on price stability could make that support less reliable going forward.

How does artificial intelligence factor into the outlook?

Artificial intelligence is helping support growth and may create meaningful productivity gains over time. However, the article notes that it remains unclear where the benefits will ultimately accrue, and the current AI buildout may also be more sensitive to higher interest rates because of its need for capital.

Why does inflation still matter for the Federal Reserve?

Inflation remains above the Federal Reserve’s 2 percent target, and recent readings have not shown enough improvement to declare the problem solved. That keeps the Fed focused on price stability and raises the risk that rates may need to stay higher, or potentially move higher, if inflation remains sticky.

What should investors take away from this commentary?

The main takeaway is that markets may still offer opportunity, but investors should not assume every pullback will be followed by the same rapid rebound seen during years of heavy policy support. Staying invested, diversified, and aligned with a long-term financial plan may help investors navigate a more uncertain environment.

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