Question

Why is capacity utilization an essential /relevant/ useful indicator to the Federal Reserve , given the mission of the Federal Reserve?

Answer 1

The Fed's mission is to promote stable economic growth, maintain a low inflation, and a low unemployment rate. The Fed uses its monetary policy tools in order to achieve these objectives.

The Fed wants to keep the real output in the economy as close as possible to the potential output. The potential output reflects the production capacity of the economy. When the real output is higher than the potential output i.e. production capacity, there is inflationary pressure and the fed reduces money supply to contract the economy and bring the economy back to the potential output level.

On the other hand, when the real output is less than the potential output i.e. production capacity, there is a recessionary pressure and the fed increases money supply to stimulate the economy and bring the economy back to the potential output level. Therefore, capacity utilization i.e. how close the real output is to the potential output is an essential /relevant/ useful indicator to the Fed.