A Check On The Output Gap Is A Check On Fed Funds

Too Wide & Too High

August 18th, 2025 - Volume 11 (2025) Missive 119 (Monday)

• The best economic predictor of Fed Funds

• Manufacturers sitting on too much for too long

• New business formation without planned wages hits new record

Typically lost in the shuffle that is the mid-month economic data dump was last Friday’s industrial production and capacity utilization. It is always a shame when this happens but nevertheless understandable when competing with the likes of CPI, PPI, and retail sales. Despite its relative anonymity, the report produces some of the most essential insights when it comes to not only the general state of the economy, but perhaps more importantly, monetary policy’s general effectiveness. For those of you who follow us regularly, you know we’re alluding to that of the capacity utilization rate and its strong historical correlation to that of Fed Funds. The tie that binds the two, of course, is that of the output gap: one reflects it and the other attempts to manage it.

You’ll not find a more correlated economic indicator to that of Fed funds then the monthly rate of capacity utilization.

Although it isn’t as sensitive as it once was, the rates of the nation’s production capacity utilization are still an economist’s best economic gauge to the output gap. Capacity utilization rates are just that: the rate at which capacity is being utilized which can parlay into the broader economy. More specifically, if the nation’s production side of the economy is only using three-quarters of its total space, it is more than fair to say the overall economy is also at or around that same amount of gap. And due to the fact that it is only through an appropriately shaped output gap that the economy can operate with stable prices and full employment, it stands to reason that Fed Funds will react to the changes in capacity utilization. This is why the two rates tend to trend together over the longer-term. However, it is also important to