When Will Fed Tighten? They Give Us The Indicator To Watch ~ Steve Blitz Morning Notes
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Saturday, August 22, 2009

When Will Fed Tighten? They Give Us The Indicator To Watch

A great way to understand what the Fed is thinking is to rummage through the Work Papers on their web site. Back in April Thomas Trimbur at the Federal Reserve Board published "Improving Real Time-Estimates of the Output Gap". Because the Fed continues to maintain that Price Index inflation is the key variable to sustain stable economic life, as opposed to credit creation, they follow the output gap concept to determine when demand is beginning to strain on the capacity to produce and so, by extension, increase inflationary pressures. Regardless that I believe this is a quaint notion in a global world, it is the Fed's view that counts and they count Capacity Utilization as the best real time indicator of the gap between actual and possible output. Here is the abstract from the paper:

This paper investigates strategies for real-time estimation of the output gap. First, I examine estimates from univariate models with stochastic cycles. This corresponds to the use of model-based band-pass filters in real-time, and I find that the turning points in real-time and final output gap series match more closely for higher order models and that the revisions properties and real-time accuracy are more favorable. Second, I investigate the use of capacity utilization as an auxiliary indicator to improve on output gap estimates in real-time. I find that this bivariate approach leads to significant gains in the accuracy of real-time estimates and in the quality of revisions.

The chart below shows Cspscity Utlization (an FRB data series) against recessionary periods. The horizontal line is the dividing line between noninflationary and inflationary growth (of course it is a more gradual and lagged process, but I am keeping it simple).

The Fed is a long way from considering s hike in the funds rate and now we know their gauge to measure just how far away they are.

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