US Economy

Following the devastation of hurricanes Katrina and Rita
in the twilight of 2005, most economists posited a sharp
rebound over the first half of 2006, as business returned to
normal and large storm damage insurance and Federal Gov. funds
went to work. And, that's exactly what we got, with the
yr/yr dollar value of production rising to a strong 8.6%. The
Federal Reserve did not "mop up" any excess liquidity, but
the real economy did. With production growth rising faster than
capacity over most of this period, inflation accelerated, driven
by already high global operating rates for oil and industrial materials.

Unwisely, I suspect, analysts raised earnings estimates for both
2006 and '07, based on the strong showing of the economy over
most of the first half of this year.

The shorter term economic indicator sets I follow point to slower
economic growth over most of the rest of this year. Moreover,
my longer lead time indicators also point to moderation of
growth ahead.

I watch the trend of capacity utilization very carefully, because
that is a critical variable for the Fed in setting monetary policy.
In the wake of the 2001 recession, capacity utilization dropped
to nearly 74% by early 2003. Those very low readings were the
worst since the brutal washout of 1981-82, and reflected a steep
decline for US manufacturing. Since Q2 '03, the US operating rate
has recovered to nearly 82%, and if the recovery trend continued
as is, the economy would hit effective capacity and strong overheat
conditions by the end of 2007. The main or underlying reason has
been the slow growth of capacity in the wake of such a steep
recession for manufacturing.

A six to nine month slowdown for the economy would take some of the
heat off inflation potential. Moreover, capacity growth may accelerate
in the interim since producers may not want to risk the chance of
losing market share a year or two out because they have no new
capacity to meet a higher level of orders.

I think the scheme outlined above is pretty much what the Fed is
aiming for. To stay out of the political fray, the Fed may want to
pause raising the FFR% ahead of Nov. '06 elections. That would
give them 2007 to tighten further if need be, so that when the
2008 presidential election rolls around, they may again be able
to stay out of the political limelight.

My shorter term inflation indicators have softened in June, and
the longer term reading continues to show a moderate downtrend.
But these are volatile series, with a wide band of commodities
prices playing a major role. In this regard, it is easy to see
why the Fed has insistently jawboned the commodities markets in
recent weeks. Breaks in oil and other key materials would make
the Fed's job easier.