What To Expect From The Fed
Next Tuesday, October 28, the FOMC will meet to determine monetary policy.
Although most market observers do not expect any change in the current 1% Fed
Funds rate, everyone will be scrutinizing the carefully worded statement in
order to determine when the Fed will begin to raise rates.
In my view, the Fed will likely convey a message that it still favors an
accommodative stance–despite ever improving fundamentals. The reason is that
prices (CPI) are still at their lowest levels since the mid-60’s.
Capacity utilization, which affects the value of prices, remains near its lowest levels in 20 years.
This economic reading measures the amount of resources being used by the
economy–a high number indicates that the available resources are being
stretched, and low numbers indicate the opposite. Typically, when capacity utilization is high, inflation becomes a concern for
the Fed. It becomes increasingly difficult for firms to
produce enough to meet additional demand for their goods when they are using all
of their available resources. And when demand exceeds supply, inflation begins
to appear. In order to prevent inflation from taking hold of the economy, the
Fed slows demand by raising rates (higher borrowing costs).
The chart below
illustrates the relationship between high levels of capacity utilization and Fed
tightening cycles. Typically, the Fed raises rates when capacity utilization
rises above 81, as this level is usually accompanied by thinly stretched
resources and therefore, higher inflation. But capacity utilization is currently
at 74.7, which is .2 higher than last month’s reading but still significantly below the 81 level.
So until this economic measure starts to increase significantly, don’t expect
the Fed to signal higher rates.
