Thursday, July 9, 2009

Capacity Utilization vs. Inflation

Yesterday, we took a look at the recent jump in used car prices and the impact the "drivers" (pardon the pun) of that jump have on inflation. In short, the cause of the jump (people drive their cars longer, thus used car supply is down) has also had a substantial impact on new car sales (they're down). This reasons that factories producing NEW cars will have extra capacity (they do), which will eventually "drive" down their prices.

And this phenomenon can be seen in historical data of capacity utilization for the broader economy and CPI. When capacity utilization has shifted, CPI has followed with a roughly six month lag.

Interesting (to me) is that it hasn't been the absolute level of capacity utilization that has impacted the "going" CPI rate, it has only been the change in that level that has. In other words, if capacity utilization stabilizes or increases in the near term, then inflation is likely to stabilize at this lower rate or come barreling back sooner than I had previously thought.

But before then, expect the negative CPI prints to continue.


Scott Grannis of Calafia Beach Pundit reads my blog (again, he is my favorite blogger to disagree with). He posts on the same topic and says (bold mine):

As a counterpart to my interpretation of events, I suggest you have a look at a similar post on EconompicData (this post) which has a chart that paints a very different picture than my chart. He argues that the change in capacity utilization has always been a good predictor (by 6 months) of inflation. I'm not all that impressed by the fit of the two lines on his chart (sometimes they move together, and sometimes they don't), and I don't think there is a logical reason to expect a strong fit in the first place.

Here's why: Idle resources and high unemployment may indeed depress the prices of some things, and may cause some workers to accept lower wages. But inflation is a condition in which all prices rise, not just some. So whatever reduction in price pressures we see as a result of rising unemployment and falling capacity utilization are not necessarily going to result in all prices falling. Sometimes a decline in capacity utilization will result in falling inflation, but not always. What's really driving inflation is monetary policy, as I've argued above.

The important thing to focus on today is that while the level of economic activity overall has fallen rather significantly from where it was a year ago, the amount of money circulating in the economy has risen significantly. Money is now abundant, whereas goods and services are relatively scarce. When the public's demand for money declines—something I think may already be underway—then we will have a surplus of money and a reduced supply of goods and services, and that is the classic recipe for rising inflation.
Shocker... I don't agree with Scott. His argument that the amount of money in circulation is what matter runs counter to my belief that credit is what unfortunately matters to prices in the U.S. (for a GREAT read on why I believe 'Credit Money' is what matters rather than 'Fiat Money' see Roving Cavaliers of Credit by Steve Keen).

But more important, Scott is "not impressed" by the "two lines" in my chart. Lets see what the math shows. Drum roll please..... the "lines" in the chart above have a correlation of 0.533 from July 1982 - November 2008 (the last date I have for CPI due to the 6 month lag). Why July 1982? Because I like to make my numbers more impressive (the correlation from June 1982 was "only" 0.504 and from August was "only" 0.522).

0.533 correlation over 27+ years?!?! Pretty darn IMPRESSIVE if you ask me...

Source: Federal Reserve / BLS


  1. My guess is the correlation makes sense because of somthing like the following. Capacity utilization changes signifcantly at some business. The managers think - better do something about that and lowers prices to try to bump capacity utilization up. I hav observed that it is the change in things that generally get people's attention and result in action not a steady state of affairs (i.e capacity utilzation being low and steady doesn't necessarily prompt action).

    I agree with you inflation is going to be down in the short to medium term and that credit is more important for inflation than money supply in an economy like the US.

  2. Demand for new cars hardly has any impact on prices: most cars are produced by unionized workforce, the raw materials are being hedged and cost of a vehicle is known well in advance. only the detroit three could afford to stockpile vehicles no one wants, and then slash prices to move the inventory. the rest of the industry is not command based.

  3. bb- you may be right on the top line, but there are a lot of ways to they can "hide" the savings if you will.

    the easiest (and done often, as well as now) is reduced financing. the current financing rate in the U.S. is 3.47% (as of May) down from over 8% earlier this year. same $20,000 price at different rates = different final price.

    the other ways commonly used are adding additional features "for free" such as a moon roof, high-end stereo, etc... but charging the same overall price.

  4. Hmmm... by only examining the data since the 80's you left out the stagflation era. Was a high correlation in place in the 70s?

  5. "But inflation is a condition in which all prices rise, not just some."

    There are many factors that determine the price of an item. I can't buy inflation described in this way. There are plenty of inflationary environments where price drops occur in certain items. Laptops are a prime example.