Capacity utilization : predictor of inflation.

Abstract

The current challenge confronting the Federal Open Market Committee of the Federal Reserve Bank (FOMC) in achieving price stability requires the facility to forecast changes in the rate of inflation and to implement timely corrective measures before the economy experiences a surge in inflation. The need for prompt and appropriate monetary policy is magnified by the existence of lags between changes in the economy (real or monetary) and price inflation. Forces tending to accelerate inflation may already be in place, but price increases may not have materialized.

The purpose of this study is to develop a model comprised of real forces (capacity utilization and other supply/demand proxies) that can be used to predict changes in inflation, thereby, alerting the FOMC of the need to embark on monetary policy aimed at preventing an acceleration of price increases. The model will be examined as to its ability to forecast future inflation using lagged values of the independent variables. The study will also examine the concept of a non-accelerating inflation rate of capacity utilization (NAICU) with respect to its validity as a monetary policy tool.

This study finds that capacity utilization plays a significant role in explaining changes in the rate of inflation. However, it would be naive to focus strictly on the NAICU as the sole predictor of inflation rate changes. Ignoring other supply/demand variables identified in this study as major contributors in explaining inflation will result in a suboptimal model of the inflation process.