Industrial production continues to recover

Industrial production in the U.S. rose modestly in August, about in line with expectations. Production is up at an annualized rate of 6% in the past six months, and has rebounded 9% from the lows of June 2009. As the top chart shows, industrial production has also rebounded all over the world since early last year, with the most notable rebound occurring in Japan.

But as this next chart shows, capacity utilization rates remain unusually low, so we'll need to see a lot more in the way of rising industrial production before the economy returns to anything that might be termed "healthy." Still, we are making progress and that is the most important thing.

In this last chart, I've added the real Federal funds rate to the chart of capacity utilization. The Fed has believed for a long time that inflation is the by-product of a very strong economy, so it is not surprising to see the strong correlation between capacity utilization and the real funds rate. When capacity utilization rates are high, the Fed sees this as a good indication that "resource slack" is very low, and thus inflation risk is high, so it tightens by raising the funds rate relative to inflation. By the same token, low utilization rates reflect a lot of idle capacity and resource slack, and that means inflation risk is low, so easier monetary policy conditions are called for. The unprecedented degree of resource slack we've experienced in this recession has given rise to the widespread concern that deflation risk is high. I don't agree with that line of reasoning (inflation is a monetary phenomenon that has nothing to do with the strength of the economy), but that's what drives the Fed so we need to pay attention. In any event, the degree of slack is declining fairly rapidly, so that means that deflation concerns at the Fed should also be declining rapidly.

Interestingly, the last chart suggests that if capacity utilization rates continue to rise, then the Fed might end up raising rates a lot sooner than the market currently expects. Fed funds futures currently show almost no chance of a tightening until next summer at the earliest. I for one would be very happy to see higher rates, and for a number of reasons. For one, it would send a positive message that things were improving. Two, higher interest rates are a net benefit to households, since the average household has a lot more floating rate assets (e.g., money market funds and bank CDs) than floating rate debt (e.g., adjustable rate mortgages). Three, a tighter Fed would provide much-needed support to the dollar, which is near the bottom end of its historical valuation range these days. A strong dollar would in turn foster more investment (foreign investors are much more likely to invest here if they believe the dollar will retain its value).