The Perfect Economy?

The U.S. economic data reported this week showed strong output growth with tame inflation. Industrial Production expanded at about 1% in June, three times greater than expected, while both the June Consumer and Producer Price Indices were unchanged. Also, the June Capacity Utilization rate rose to 80.0%, and the June Unemployment Rate fell to 5.0%. The June data generally show there is neither strain nor slack in the U.S. economy. Therefore, the U.S. economy is expanding at an optimal rate.

It seems, the "Goldilocks" economy (of neither too hot nor too cold) may continue for several months. The longer-term trend has shown slowing output growth with rising inflation (i.e. stagflation). In 2003 and 2004, the U.S. economy expanded at about 4.0% real growth, while inflation rose from 1.6% to about 3.0%. Sustainable growth, which is optimal, is 2.7% real growth. So far in 2005, output growth has slowed to just above 3.0% real growth, while inflation has stabilized or fallen somewhat.

U.S. output growth and inflation have been quite impressive, over the past few years, after the bubble boom in the late '90s (where resources were under great strain) and the shallow recession in 2001 (during of a massive "Creative-Destruction" process, which made the U.S. economy more efficient). The U.S. economy owes a great debt (no pun intended) to the skill of the U.S. Federal Reserve (Greenspan & Company) for smoothing-out the business cycle, and to a lesser extent the (continuing) stimulative fiscal policies of the Bush Administration.

Future inflation is both actual and expected inflation. The U.S. Federal Reserve has done a masterful job lowering inflation expectations, through a combination of actual tightening and "jawboning." However, to keep future inflation in check, the Fed may need to tighten (at a "measured pace") at each FOMC meeting this year, because monetary policy is still quite accommodative, and the lags in monetary policy force the Fed to work in the future economy.

NAIRU (the Non-Accelerating Inflation Rate of Unemployment) is estimated to be 5.0%, which is where the Unemployment Rate fell to last month. Also, the Capacity Utilization Rate rose to 80%, and over 80% is an indication of rising or accelerating inflation. Moreover, the output gap (between potential and actual output) has closed, taking the slack out of the economy. So, the U.S. economy is "perfect." To maintain the optimal growth rate, the Fed will need to correctly anticipate the future economy and make the appropriate adjustments. The Fed has done an excellent job bringing the economy up to "perfection." However, it may need to continue tightening until monetary policy reaches a neutral stance, and then tighten further to preempt inflation and maintain price stability.

Arthur Albert Eckart is the founder and owner of PeakTrader. Arthur has worked for commercial banks, e.g. Wells Fargo, Banc One, and First Commerce Technologies, during the 1980s and 1990s. He has also worked for Janus Funds from 1999-00. Arthur Eckart has a BA & MA in Economics from the University of Colorado. He has worked on options portfolio optimization since 1998.

Mr Eckart has developed a comprehensive trading methodology using economics, portfolio optimization, and technical analysis to maximize return and minimize risk at the same time. This methodology has resulted in excellent returns with low risk over the past five years.