The Fed Relies On Its "Gap Chart"

The FOMC finished up today. They left policy unchanged and
commented that the recession and price deflation are easing and
that sustained inflation is not in sight. they are relying on a tool --
the "Gap Chart" -- a tool that has been a cornerstone of monetary
policy for longer than most of you have lived. The chart compares
the trend of production and capacity and measures whether the gap
is growing or retreating. A growing gap means capacity is advancing
faster than production, which means the operating rate for the
economy is receding and that so should inflation pressure. The gap
is huge now, with the operating rate at a low 68% and still falling.
So, for now, the Fed sees no reason to expect a sustainable rise
of inflation pressure.

They have been dead wrong on this since late winter. Inflation
pressure -- measured without seasonal adjustment -- has been on
the rise even as the production / capacity "gap" has opened
wider. The FOMC did not acknowledge this fact today and has
opted to project that continued US and global economic slack will
kill off inflation pressure from rising commodities prices in the
weeks and months ahead.

Commodities players have an accomodative monetary policy at
their backs and are also armed with the knowledge that since the
recession in new order rates has been unwinding rapidly, prices
should improve with needed inventory restocking. When the
economy does come off deep recession, commodities can bounce
sharply on inventory pipeline refilling, only to settle back as
players realize that underlying demand, although set to recover,
must rise from very low levels. That is the Bernanke bet for the
time being. If commodities players, which now include the big
hedgies and long only funds, can keep the markets stoked, the
Fed will fall well behind the curve.

Commodities do exhibit a slight bias toward seasonal weakness
over the second half of the year, but not nearly enough to rescue
the bet. That will require a round or two of profit taking by
the speculators who have had the markets in play.