Steve Blitz Morning Notes

If the slight uptick in capacity utilization in July (68.5 vs 68.1) marks the recession's end then we can figure at least 35 months before the Fed's tightening cycle begins. We know now the Fed uses capacity utilization as the real time indicator of economic activity (see "When Will Fed Tighten?. . .") that gauges when to begin taking away monetary stimulus. As the chart below indicates, capacity utilization bottoms with recession's end and the Fed's policy response has always lagged. Back when inflation was more of a problem the lag was shorter (see table below). After the past two recessions the Fed waited for capacity utilization to be near 6% above its low before tightening -- and that took 35 months on average.

Current events conspire to give us a much longer period before the Fed acts for many reasons, among them are the severity of the downturn and the damage to consumer balance sheets. Waiting for a 6% increase in utilization rates means taking away monetary stimulus when usage is still below the lows of the previous recessions. With inflation far from a problem and export growth a priority, the Fed is going to want more than a 6% increase in usage before the tightening cycle begins anew.

The January 2011 Fed funds contract is trading at 98.56 implying an average effective funds rate of 1.44% or about 120 basis points above current levels. You can look at the forward rates implied in the Treasury yield curve and find similar expectations of Fed tightening. Seems to me the market is way off base. It will be 2012 before the tightening cycle begins.

Capacity Utilization & When The Tightening Cycle Begins
			Recession's End Month
			Nov-70	Mar-75	Nov-82	Mar-91	Nov-01	Jul-09
Capacity Utilization			77.85	74.46	71.47	78.73	73.63	68.07
Fed funds Rate			5.6%	5.5%	9.2%	6.1%	2.1%	0.2%
Months To First Rate Hike			16	24	7	38	32	??
Capacity Utilization			83.69	83.77	74.06	83.39	77.74	72.15
Capital Utilization %Ch			7.5%	12.5%	3.6%	5.9%	5.6%	6.0%