Chicago Fed index improves but outlook less encouraging

The US economy improved in July, according to the Chicago Fed National Activity Index.

Led by improvements in production-related indicators, the Chicago Fed National Activity Index increased to –0.06 in July from –0.38 in June. Three of the four broad categories of indicators that make up the index improved in July; only the sales, orders, and inventories category deteriorated from June.

The index’s three-month moving average, CFNAI-MA3, increased to –0.29 in July from –0.54 in June. July’s CFNAI-MA3 suggests that growth in national economic activity was below its historical trend. Likewise, the economic slack reflected in this level of the CFNAI-MA3 suggests subdued inflationary pressure from economic activity over the coming year.

The trend in the Chicago Fed National Activity Index has historically correlated well with the trend in the spread between the 10-year Treasury yield and the federal funds rate. The Chicago Fed index tends to lag the spread, befitting the latter's status as a leading economic indicator.

With this correlation in mind, the recent development in the spread between the 10-year Treasury yield and the federal funds rate is ominous. The 10-year yield has declined from well over 3 percent in the first half of this year to just over 2 percent in recent weeks, leading to a corresponding fall in the spread since the federal funds rate is anchored at just above zero.

If the past correlation between the spread and the Chicago Fed National Activity Index persists, then the recent decline in the former indicates that in coming months, the latter could fall to a level close to those that had been associated with recessions in the past.