With this week’s further cut, the Federal Reserve has brought its target Fed funds rate below the annual increase in the “core” personal consumption price index (2.0% versus 2.1%). Historically, this measure of real interest rates has become negative only well into or after recessions – see first chart. Indeed, in two cases – the 1980 and 1981-82 recessions – real rates troughed above zero.

With the advance first-quarter GDP estimate suggesting marginal growth (0.6% annualised), a recession has yet to be confirmed – see also here. Intrade’s recession contract now implies a 33% probability of two consecutive negative GDP quarters in 2008, down from a recent peak of 79%.

The Fed normally requires evidence of significant economic slack before easing policy aggressively. Both the unemployment rate and industrial capacity utilisation are currently little different from their averages over the last five years.

A useful survey-based measure of industrial capacity pressures is the ISM manufacturing “supplier deliveries” index, based on the number of purchasing managers reporting longer delays in obtaining production inputs. An index level of 52 has historically separated periods of Fed easing and tightening – see second chart.

The index was modestly below 52 between February and November last year, signalling rate cuts, although not to the extent actually delivered. It has recovered more recently, reaching a 20-month high of 54 in the April survey released yesterday.

The current divergence between capacity use indicators and the level of real interest rates is unsustainable. Unless capacity pressures ease significantly, the Fed may be forced to consider reversing recent cuts later in 2008.