How fast can slack be consumed? How can we measure the speed at which slack is consumed?
If we look at capacity utilization and unemployment as variables for slack, we can set up a simple measure of consuming slack by dividing capacity utilization by the unemployment rate in terms of percentage change year-over-year. (Thanks to Alan Thomson at Terra Firma Financial for the graph.)
(I put the graphs below on the right here of this blog. They will be updated automatically.)
When the plot is positive, slack is being consumed on a year-over-year basis. When the plot goes negative, slack is widening. The height of the plot gives us an estimate of how fast slack is being consumed in terms of both labor and capital.
We can see that since the beginning of 2014, the consumption of slack has accelerated... and has reached a level of 25%, which in the past signals a peak. The normal pattern would then say that such an accelerated consumption of slack can be maintained only for a while, then the plot will decline as slack is consumed at a slower pace.
The speed of consuming slack is important to the Fed... and will determine when nominal rates begin to rise.
Here is the graph using quarterly data. (quarter-to-quarter % change) (link)
2nd quarter 2014 rose quite a bit from 1st quarter to over 7%. A rise like that is not common in the past. One might expect the plot to decline back down fairly quickly. And this is what we will see. With just one month of capacity utilization data to complete the 3rd quarter, the plot in this quarterly graph will most assuredly decline to below 2%.
In theory, as long as the plot stays positive, more slack is being consumed. However, look at the pattern in past business cycles. Towards the end of a business cycle, the economy shows a downward trend in its ability to consume slack. Eventually, there is a recession and slack widens again.
If you had used these graphs back in 2007, you would have suspected a recession forming months ahead of time. So these graphs of "slack consumption" are good to put in your toolkit. (I put them to the right here on this blog where they are updated automatically.)