During its twice quarterly FOMC meetings, the Federal Reserve releases a statement that explains why it has the monetary policy that it does. Quoting the FOMC statement, "In particular, the Committee decided today to keep the target range for the federal funds rate at 0 to 1/4 percent and currently anticipates that economic conditions-including low rates of resource utilization and a subdued outlook for inflation over the medium run--are likely to warrant exceptionally low levels for the federal funds rate at least through late 2014." Now, most of the focus on low rates of resource utilization is on the Unemployment Rate which is currently above 8%. In this post, I am going to focus on the other aspect of resource utilization - Capacity Utilization from the Federal Reserve's G17 Report.
Currently, Capacity Utilization stands at 78.6% for all industries and at 78.3% for Manufacturing. Why is this so important? Because, with the current rate of capacity take up, Capacity Utilization Rates will be greater than 80% by the end of 2012.
Historically, the Fed has started raising interest rates when the Capacity Utilization rate has been between 80-82%. In February of 1994, Manufacturing Capacity Utilization was at 81.4% before the Fed first raised rates. In early 1999, Capacity Utilization was barely 81 -82% when the Fed started the tightening that killed the Stock Market Bubble. In 2004, Capacity Utilization was actually below 80 when the Fed started "normalizing interest rates."
We can pretty much already figure out what the change in Capacity Utilization will be over the next 6-12 months given the current level of the ISM New Orders survey. The New Orders survey leads Industrial Production growth. On the chart to the left, Industrial Production growth is in the 1-1.5% quarterly growth range based on the current level of New Orders. This translates into about a 5% annual change in Industrial Production.
Once the Capacity Utilization rate rises above 80, expect the hawks on the FOMC to elevate their calls for policy to be normalized.
While I am not predicting an increase in the Fed Funds rate in late 2012 or early 2013, if the economy weathers the impending tax increases at the end of 2012, I would expect the Fed to move to normalize rates rather quickly in late 2013.