Monetary Policy

A more challenging period for policymakers may lie ahead. Right now, my policy gauge indicates
50% odds in favor of lifting the Fed Funds Rate, but if present trends hold in the shorter term, the
odds will soon turn to +75% assuming commercial and industrial loans continue the uptrend just
started. The one critical indicator which remains on the low side is factory capacity utilization
which at 76%+ is still well below the 80-82% level which normally signals that a more pronounced
cyclical acceleration of inflation should be in the cards. Since capacity growth itself may only be
starting to recover, operating rates can rise significantly further this year on moderate production
growth.

The standard maneuver to raise the benchmark FFR% is to draw reserves out of the system. From
a timing perspective, I think Bernanke at least would prefer to allow completion of the $600 bil.
QE 2 program on 6/30 before turning toward reversing the build up in Federal Reserve credit. A
substantial number of Board members may wish to reverse or freeze the QE program earlier
than does Bernanke if private sector credit demand starts accelerating sharply as it has in
previous recoveries after demand finally turns the corner.

There is a growing number of economists / strategists who now think that with the economy
looking stronger, the QE programs will end on 6/30 if not very shortly thereafter. So, it is
becoming more popular to prophesize on how to play the markets after QE. On this score, I
intend to follow my policy gauge indicators and leave the strategizing to others. I say this
because we need to see how firmly C&I loans may recover to determine the wisdom of
cutting off or shelving QE. On this score, my short term credit demand / supply pressure gauge is
just returning from negative territory to equilibrium at zero%. A fast rise in the gauge would signal
that credit demand growth is outstripping the growth of the broader base of loanable funds, a
situation the Fed has rarely ignored. Far more modest upward pressure on the gauge might, for
example, give the Fed some pause. Also, remember that the banks are starting to lend more
even though loan loss reserves remain at very high levels. We may have to factor that into the
equation as well.

You can keep an eye on the 1yr. Treas. bill % to see how market players may be handicapping
Fed. policy intent. ( When business loan demand accelerates, banks may well liquidate shorter
duration Treasuries to meet that demand.) 1yr. T-bill%