The Phantom of the Fed

EARLY this week, the Federal Reserve Board will raise the federal funds rate, breaking the seal on the worst-kept secret since the Marc Anthony-Jennifer Lopez wedding.

During the past year, the Fed kept rates low even as the economy expanded and as signs of rising prices - in oil, rolled steel and Upper East Side co-ops - became more evident. The reason was that Alan Greenspan, the Fed chairman, and his colleagues feared the specter of deflation. And it seemed that they had good reason to do so.

The core Consumer Price Index, which excludes volatile energy and food prices, was falling sharply, to a year-over-year rate of 1.1 percent in December 2003 from 2.7 percent in November 2001. That usually does not happen when the economy is accelerating out of a recession, and signs of unwanted slack abounded, from the labor market to industrial capacity.

But in recent months, a chorus of voices, including some within the Federal Reserve, has suggested that technology, globalization and the Fed's own recent aggressive actions may have skewed the numbers on which it relies.

Consider capacity utilization, a measure of how much of the nation's industrial infrastructure is being used. The Fed reported that this figure was 77.8 percent in May, up from 74.1 percent in May 2003, but significantly below the recent historical average of 81.1 percent - from 1972 to 2003.

In the past, low industrial capacity rates meant that a large number of factories were off line, often temporarily.

But in May, Anthony M. Santomero, a Fed governor, suggested in a speech that "with the recent pace of technological change, a disproportionate share of that stock may be obsolete." And if that is the case, he said, "the true degree of slack in industrial capacity, and hence the downward pressure on inflation, may be overstated."

He has a point. The problems affecting manufacturing in recent years have not been cyclical, as they may have been in the past; they are structural. The manufacturing capacity of Pennsylvania, Ohio and much of the world is moving to places like Shenzhen. Many textile and steel factories that are idle today may be permanently mothballed, or simply broken down and placed on fast boats to China.

"To the extent anyone is pointing to capacity utilization as a reason why you don't have to worry about inflation, they're frozen in time," said Lakshman Achuthan, managing director at the Economic Cycle Research Institute in New York.

What's more, an alternate measure of capacity utilization shows significantly less slack. Twice each year, the Institute of Supply Management surveys 400 manufacturing companies and asks what percentage of their capacity is in use. In April, the figure stood at 85.6 percent, up sharply from 80.1 percent in December 2003...