Checking In on Capacity Utilization

Source: BLS / Federal Reserve

Capacity Utilization Passing "CACU" Levels

Bloomberg details:

Industrial production advanced 0.9 percent in July. Although the index was revised down in April, primarily as a result of a downward revision to the output of utilities, stronger manufacturing output led to upward revisions to production in both May and June. Manufacturing output rose 0.6 percent in July, as the index for motor vehicles and parts jumped 5.2 percent and production elsewhere moved up 0.3 percent.

The output of mines advanced 1.1 percent, and the output of utilities increased 2.8 percent, as the extreme heat during the month boosted air conditioning usage. At 94.2 percent of its 2007 average, total industrial production for July was 3.7 percentage points above its year-earlier level. The capacity utilization rate for total industry climbed to 77.5 percent, a rate 2.2 percentage points above the rate from a year earlier but 2.9 percentage points below its long-run (1972-2010) average.

While output and capacity utilization increased, they are both still well below pre-2008 crisis levels pointing some (including me) to think inflation will be a lesser concern, than most, as there is still plenty of capacity. My own personal devil's advocate is the below chart that compares current capacity utilization levels to rolling ten year averages (call it the cyclically adjusted capacity utilization... through "CACU" doesn't have a ring to it).



On this basis, two of the three sectors are at or above their CACU. If capacity was taken offline (i.e. is not really there) due to the downturn, this would indicate that we would be much closer to a capacity shortage than comparing to previous levels.

Source: Federal Reserve

Still Too Much Capacity

The below chart shows that capacity utilization in the system is slowly recovering, but remains remain very low.



This in part explains why core inflation remains muted, even with the recent commodity spike.

Source: Federal Reserve / BLS

Capacity and Inflation

My view yesterday of inflation.

My view? Unless we see a pickup in employment (we may), all the stimulus (fiscal and monetary) will just feed into the rise we are seeing in commodities, not overall price levels. If corporations / individuals don't see a corresponding pickup in profits / income, then all this means is less money for non-core items. The result? A split between headline and core inflation. Just what we have seen thus far...

Capacity utilization strongly (in my opinion) supports this view. While excess capacity has declined (a lot) since the lows, it is still very low relative to historical levels WITH THE EXCEPTION OF MINING (in the U.S. at least - globally levels may be different, though unlikely.



Result? The potential for commodity and core inflation to remain bifurcated going forward.

Source: Federal Reserve

Capacity Utilization Jumps in July

Daily Finance details:

Don't write-off the U.S. economic recovery just yet. The nation's industrial sector, which has led the expansion but cooled recently, showed signs of renewed life in July, with industrial production climbing a better-than-expected 1%, the U.S. Federal Reserve announced Tuesday.

Capacity utilization jumped to 74.8% in July from 74.1% in June. The 74.8% utilization rate is 5.7% higher than a year ago, but is still 5.7 percentage points below its 1972 to 2009 average of 80.5%.

A Bloomberg survey had expected industrial production to rise 0.6% in July and the capacity utilization rate to rise to 74.5%. Industrial production fell 0.1% in June and rose 1.3% in May.

Source: Federal Reserve

What Stinkin' Inflation?

Briefing.com details a thought EconomPic has relayed for quite some time... that inflation is not the concern:

The CPI data for May provide further affirmation that the Fed will be on hold for some time yet. Inflation pressures are simply not a problem at this juncture. The trend in both total CPI and core CPI is clearly one of disinflation, which is apt to stoke commentary about a possible turn to a deflation environment.

Consumer prices declined 0.2% in May, slightly lower than the -0.1% decline in April. The Briefing.com consensus expected the index to fall 0.1%. Total CPI is up 2.0% year-over-year versus a 2.2% increase in April.

Core prices, which exclude food and energy, increased 0.1% (consensus +0.1%). The year-over-year core CPI growth rate has fallen to 0.9%, well below the Fed's target level of 2.0% - 2.5%.

Year over Year Change in CPI



Excess Capacity in the System (and the relationship to price levels)



Source: CPI / Federal Reserve

Capacity Utilization Increases (Remains Low)

Business Week details:

Capacity utilization, or the proportion of plants in use, rose to 73.2 from 73 percent in February.

Industrial capacity utilization was estimated to rise to 73.3 percent, according to the Bloomberg survey median. The rate averaged 81 over the past four decades. Economists track plant operating rates to gauge factories’ ability to produce goods with existing resources. Lower rates reduce the risk of bottlenecks that can force prices higher.

Excess capacity is one reason Fed policy makers see little risk of inflation. Fed Chairman Ben S. Bernanke yesterday said the rate of increase in consumer prices was “subdued,” and said “moderation in inflation has been broadly based.” He also said economic growth will remain “moderate” as the economy contends with weak construction spending and high unemployment.

The chart below shows the historical relationship between the change in capacity and headline CPI. Please note that the below chart only reflects the change in the year over year figure, thus the 2.8% jump in CPI is the difference between the latest 2.4% print and March 2009's -0.4% print.



Another way to view it...



Source: Federal Reserve / BLS

Industrial Production Grows Despite Weather

WSJ reports:

U.S. industries reduced manufacturing output in February because of severe weather, while overall production totals inched ahead slightly. Industrial production last month increased by 0.1%, the Federal Reserve said Monday. That falls in line with the expectations of economists surveyed by Dow Jones Newswires. January output remained unchanged at 0.9%.

The biggest gain in the report showed output in the mining industry rose 2.0% after climbing 1.1% in January. Mining capacity use rose to 88.2% from 86.4%. Still, manufacturing production in February decreased 0.2% from the previous month's 0.9% increase, the report said. Car and parts output showed a steep dip of 4.4%. excluding autos, production in all other industry remained stagnant.

Source: Federal Reserve

Production Continues to Recover

Marketwatch details:

Colder-than-usual weather contributed to the gain in December, with utility production rising a seasonally adjusted 5.9%. The output of factories dropped 0.1% in November after a 0.9% gain in November, repeating the see-saw pattern of the past four months. Output of mines rose 0.2%. Read our complete economic calendar and consensus forecast.

For all of 2009, output plunged 9.7%, the steepest yearly decline since output fell 13.7% in 1946. Output fell at a 12.5% annual pace in the first half of the year, then rose at a 9.6% annual pace in the final six months of the year. Since the recession began two years ago, industrial output dropped 10.8%. Manufacturing output fell 13.2% since the recession began.

In December, capacity utilization in industry rose to 72% from 71.5%. It's the highest in a year. For manufacturing, capacity utilization rose to 68.6% from 68.5%, also the highest since December 2008. The utilization rate in the factory sector -- a measure of slack in the economy -- is 11 percentage points below the long-term average, showing very weak inflationary pressures.

And the relationship between capacity and inflation remains strong.



Source: Federal Reserve

Can Capacity Destruction be Good for GDP?

Notice that I state GDP and not "the economy" in the headline (the broken window theory explains why destruction is not good for the economy, BUT it doesn't mean that it won't lead to a better GDP print down the road). As Richard Posner details, there are many issues relying too much on GDP:

But it is necessary to emphasize that it is just a starting point. I disagree with economists who say the “recession” ended in the third quarter. The depression (as I think we should call it if only because of its enormous potential political consequences) has caused massive unemployment with all the associated anxieties and hardships, has greatly reduced household wealth, has caused private investment to turn negative, has cost the government trillions of dollars in lost tax revenues and recovery expenditures (TARP, the fiscal stimulus, the mortgage-relief programs, the auto bailouts, etc.), has undermined belief in free markets and altered the line between government and business in favor government, and is threatening a future inflation while deepening our dependence on foreign lenders. To view a change in GDP from negative to positive as signifying the end of a depression (by which criterion the Great Depression ended in 1933 and again in 1938) is to misunderstand the utility of GDP as a measure of economic activity.

Historical Capacity Destruction

That said, as I initially stated in my post on capacity destruction:

Capacity utilization is utilized capacity / total capacity. This means that the change in capacity utilization may not only be due to a change in the numerator (utilized capacity), but in the denominator as well (overall capacity). And my guess is overall capacity is actually decreasing for the first time since the telecom overbuild collapse in the early 00's.

Reader Dennis Oullet pointed out that while I was correct, I went the difficult route to get to that point (full historically data is available on the Fed's website).

And here is that data showing the year over year change in total capacity going back to the early 1980's.



While the recent period has seen overall capacity removed from the system, the lack of capacity build since the telecom bust (2001) is even more striking (below is a chart showing 8 year rolling periods, which matches the time frame since that telecom bust).



Capacity Reduction --> Higher GDP Print?

Reader dblwyo made an interesting point that:

A complementary notion is that industry grossly under-invested relative to growth in the 00's and drove utilization higher, i.e. let equipment die off. That guess seems to tie a lot of things together.

So while we overbuilt toward the end of the 1990's, we have since under-invested as we outsourced production to cheap Asian labor, grew the economy via the housing / financial sectors rather than manufacturing, and ran into the worst economic slump since the Great Depression (or WWII at a minimum).

Combined with the recent capacity destruction, am I crazy to think that businesses may NEED to invest in new (or upgraded) capacity sooner than many think? My thought is along similar lines of how inventory restocking may lead Q4 '09 GDP to grow as much as 5% (per David Rosenberg):

We mentioned two days ago, there is an outside chance that we could see Q4 real GDP approach a 4-5% range at an annual rate, well above current consensus expectations (currently the Bloomberg consensus is expecting a 3.0% increase in GDP). A good chunk of that is in inventories, not final demand, but so be it.

Why can't capacity replacement lead to higher GDP prints as well (again, separating GDP from the actual economy)? Obviously the timing of this may be off (i.e. I can't imagine it occuring when capacity utilization is near all time lows, unless some new technology springs to life), but as capacity continues to be taken off-line (i.e. destroyed), couldn't the replacement be a surprise upside for GDP?

Source: Federal Reserve

Capacity Destruction?

Upon further review of capacity utilization...

The chart below shows the year over year change in industrial production, capacity utilization, and the difference between the two. In a world in which productivity is booming (it is), that means people are making more... with less. Thus, productivity "should" be rising more than capacity utilization all else equal. However, as the chart below shows... it is not.



Why? Well, here's my theory... capacity utilization is utilized capacity / total capacity. This means that the change in capacity utilization may not only be due to a change in the numerator (utilized capacity), but in the denominator as well (overall capacity). And my guess is overall capacity is actually decreasing for the first time since the telecom overbuild collapse in the early 00's.

Thoughts?

Source: Federal Reserve

Update:

Reader Dennis Oullet points out that while I am correct, I went the difficult route (overall capacity data is available on the Fed's website).

Capacity Utilization and Production Rebounding

Reuters reports:

U.S. industrial output rose firmly in November as the manufacturing sector extended a recovery that economists hope will help turn around the ailing labor market.

Production climbed 0.8 percent, the Federal Reserve said on Tuesday, well above forecasts for a 0.5 percent gain. The strides were powered in part by the automotive sector, and came despite a sharp drop in utility output. Capacity utilization, the amount of the nation's industrial capacity being put to use, rose to 71.3 percent in November from a revised 70.6 in October, its highest level since last December but still well below the long-range average.

Update:

An Anonymous reader didn't like the post.

Come on Jake. This reporting is hugely inaccurate. If we really want BS spin reporting, we'll just watch CNBC! A prosuction increase of .8 percent is not significantly above a forecast of .5 percent. This is noise. Capacity Utilization is much closer to the bottom than 2007 levels. Your graph does not illustrate that at all.

While I did enjoy his candor... my response:

I will defend myself and say I used the word "spike" not "rebound".

After the freefall we saw from late 2008 through early 2009, I'll agree that we need a "spike" to get the economy back to trend, BUT a rebound is better than a continued decline.

And the data seems to show just that.



Does this mean the "rebound" is sustainable? Not necessarily, but it has been a rebound none-the-less.

Source: Federal Reserve

Auto Prices and CFC; CPI and Capacity

Marketwatch details the latest CPI release:

The consumer price index increased a seasonally adjusted 0.3% in October as energy prices increased for the fifth time in six months to offset another rare decline in rents, the Labor Department said.

The core CPI rate, which excludes food and energy prices in order to get a better look at underlying inflation in the economy, rose 0.2% last month, led by higher prices for cars and trucks, due in part to the unwinding of the government's "cash-for-clunkers" incentives program.

Prices for new cars rose 1.6%, the most in 28 years. Used-car prices also increased, up 3.4%, the most in 29 years.

The consumer price index has fallen 0.2% in the past year. The core CPI is up 1.7% in the past year. In September, the CPI and the core CPI were up 0.2%.

Autos and Cash for Clunkers

For the relationship between used car prices (legitimately higher) and cash for clunkers go here. And while cash for clunkers also plays the role in why prices of new cars increased, it is not permanent (i.e. not legitimately higher), but what I would classify as a reporting blip. Broadly it goes like this... no cash for clunkers + no change in methodology to account for no cash for clunkers = higher prices feeding into CPI. Per the BLS:

The BLS did not change its estimation method to incorporate the cash for clunkers program. The standard method for estimating the transaction price on sampled new vehicles calls for collecting the retail price of the vehicle and its selected options, and asking the dealer for the average discount on that sampled model over the previous 30 days. The 30 day average is used because sales volumes per specific model per month are typically low at individual dealerships.

To the degree that the total dealer discount to the consumer is influenced by discounts or incentives to the dealer from any source, including the cash for clunkers program, it would be reflected in the CPI. The average discount for sampled vehicles would reflect both cash for clunker transactions as well as transactions not eligible for the program.

As mentioned yesterday, the opposite was true for PPI (autos were a drag on PPI as producer pricing of autos were impacted less directly than prices to the consumer). In other words, expect CPI to bounce back (at least the auto portion) in November.

CPI and Capacity Utilization

As for relationships to keep an eye on regarding future CPI prints; think capacity utilization. As I detailed back in July, the relationship between capacity utilization and CPI (lagged six months) has been very strong for more than 30 years.



So, if you think capacity will come back (good) or be eliminated from the system (bad) [i.e. numerator vs. denominator] eliminating excess capacity, then you probably should gear towards higher inflation (sell fixed rate bonds, buy who knows... depends on if the "good" or the "bad"). If you think capacity will remain low due to continued production capacity staying off-line (very possible) or new capacity being added (not likely), then inflation will likely be in check (fixed rate bonds = opportunity).

Source: BLS / Federal Reserve

Output Gap and Inflation

Marketwatch details:

Output of the nation's factories, mines and utilities rose 0.7% in September after an upwardly revised 1.2% gain in August and a 0.9% increase in July, the Fed said. The 0.7% increase in output in September was stronger than the 0.4% gain expected by economists surveyed by MarketWatch. Manufacturing output rose 0.9% in September. Capacity utilization rose to 70.5% in September from a revised 69.9% in August.

Looking at the chart below, we see an improvement in the year over year decline in capacity utilization, which indicates less disinflationary pressure in the system.

BUT, Macro-man details why inflation may tick up before the level of capacity utilization increases:

However, it's probably worth touching on some small aspect of the debate, as behind the scenes it seems as if the same is happeneing at the Fed. Don Kohn's recent speech highlighted the large size of the output gap, a view largely echoed in last night's FOMC minutes. Yet at a recent St. Louis Fed conference, Bank president James Bullard offered a somewhat contrary view-namely that the collapse of the bubble has eradicated some of the productive capacity of the economy, thus rendering the output gap smaller than commonly believed.

And an example of how a decrease in the value of a dollar may play into the inflation/deflation debate (i.e. a weak dollar will make it more difficult to import disinflation from overseas):

While it's certainly the case that import prices from China are still down year-on-year, intriguingly, the quarterly change in import prices has returned to zero. In other words, there is no marginal deflationary trend in US import prices from China. If (or rather, when) domestic inflation in China starts to rise, courtesy of PBOC's helicopter money-drop, it seems reasonable to posit that US import prices from China will begin to rise.

Source: BLS

Production and Capacity Utilization Up

Marketwatch reports:

The output of the nation's factories, mines and utilities rose 0.8% in August. Output was also much stronger in July than first estimated, the Federal Reserve said Wednesday. The August increase was just a bit better than expected by economists surveyed by MarketWatch. Analysts had been expecting a 0.7% gain. Capacity utilization - a gauge of slack in the economy -- rose to 69.6% in August from a revised 69.0% in July. There were gains across the board in August. Manufacturing expanded 0.6% in August. Excluding autos and auto parts, manufacturing rose 0.4%.

An economic rebound is definitely under way, how fast and far that rebound is remains to be seen. That said, I am impressed by the strength in output outside of the manufacturing sector. As I detailed yesterday, capacity utilization has historically had a strong relationship with employment.

In addition, the increase in capacity utilization decreases the worry over deflation (though not out of the woods yet). The relationship between capacity utilization and inflation was detailed here and we may be seeing the beginning stages of what may be a reflationary period that the broader investment community had been worried about for some time.

Source: Federal Reserve

Capacity Utilization vs. Unemployment

August's capacity utilization figure to be released tomorrow is forecast at an improved 69.6% from 68.5%. The importance of that figure is it tends to be a leading indicator of inflation. Per the NY Fed:

The level of capacity utilization in the industrial sector provides information on the overall level of resource utilization in the economy which may in turn provide information on the likely future course of inflation.

More importantly perhaps, capacity utilization has been a rather reliable leading indicator of the future unemployment rate. The below chart shows just that with unemployment rate in blue (left hand side) vs. capacity utiliation in red (reversed on the right hand side).

Though it should be noted that August should include a substantial bump in capacity utilization via the cash for clunkers program. Thus, it will important to look at the breadth of any rebound in utilization.

Source: Federal Reserve / BLS

Capacity Utilization Jumps from 17.4% Increase in Automotive Production

The good news... a 0.5% jump in industrial production and an increase in capacity utilization. The bad news... capacity utilization jumped to levels last seen... in April (i.e. not much) even with the MASSIVE 17.4% increase in auto production due to the cash for clunkers program.



And the update of the capacity utilization vs. CPI chart, which shows CPI may be bottoming in a few months. Details of this analysis can be found here.



Source: BLS / Federal Reserve

TOTAL Capacity in Economy Shrinking

I'll play my own devil's advocate regarding my initial conclusion to capacity utilization. To rewind... in my post about used cars and the inflation / deflation tug of war, I concluded (re: excess capacity):

To me this is deflationary over the longer run, with one HUGE caveat / concern... supply destruction.

This story shows what can happen when there is a significant change in supply (lower supply = higher prices). My fear is that the global economy has another downturn and supply is permanently destroyed when the government finally accepts that they cannot save every GM, Chrysler, etc... At that point I do feel that inflation, even with reduced demand, is a real threat. BUT, until then, deflation is my concern...

The "until then" may be coming sooner than I thought. The following chart shows the annualized monthly change in TOTAL CAPACITY (not capacity utilization) in the economy today.



While of limited concern in an environment with as much excess supply as we currently have, it may be of increasing importance as the economy comes back going forward.

Source: Federal Reserve

Capacity Utilization at Record Low

Another better late than never post as I'm still on the road... this morning's industrial production and capacity utilization release (via RTT News):

The Federal Reserve noted that output in the second quarter as a whole fell at an annual rate of 11.6 percent, a more moderate contraction than in the first quarter, when output fell 19.1 percent.

Decreases in output in both the manufacturing and mining sectors contributed to the continued drop in industrial production in June. While manufacturing output fell by 0.6 percent, mining output fell 0.5 percent.

On the other hand, the output of utilities increased by 0.8 percent in June after decreasing in each of the four previous months.

The report also showed that the capacity utilization rate fell to a record low of 68.0 percent in June from a revised 68.2 percent in May. Capacity utilization had been expected to fall to 67.9 percent compared to the 68.3 percent originally reported for the previous month.

A record low not only in aggregate, but also in manufacturing, mining, AND utilities.



And an updated (shortened) version of my chart with unimpressive fit.



Source: BLS / Federal Reserve

I'm Impressed with the Fit...

I posted the below update directly to yesterday's post on Capacity Utilization vs. CPI, but as it was late in the day, had already moved down the blog, and involved the questioning of the validity of one of my beautiful charts, here it is again with a bit of additional analysis.

Scott Grannis of Calafia Beach Pundit apparently reads my blog, which is cool (for those that missed my earlier post, he is my favorite blogger to disagree with). He posted on the same topic of capacity utilization vs. CPI (bold mine). Here is an excerpt:

As a counterpart to my interpretation of events, I suggest you have a look at a similar post on EconompicData 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 is the chart from yesterday which is referring to...


Before I defend the chart, I must defend myself. I never said capacity utilization has ALWAYS been a good predictor of CPI (that would be foolish). The only thing I know that "always" follows something is my interrupting someone after I've had a few beers. I think "generally" would be the term I would have used.

But more important to the credibility of EconomPic is that Scott is "not impressed" by the "two lines" in my chart. To me the relationship seems strong, but let's see what the math shows.

Drum roll please.....

The monthly "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).

And over 1, 5, 10, 20, and 30 years? Well, here's the chart...


Our back and forth reminds me of an article I just read over at Time.com, Yes, I Suck: Self-Help Through Negative Thinking. In the article they detail a study, which I feel is at the heart of our argument and the need for Scott to say that "he isn't impressed by the lines on the chart" and my need to update not only my original post, but add this one as well.

The study's authors, Joanne Wood and John Lee of the University of Waterloo and Elaine Perunovic of the University of New Brunswick, begin with a common-sense proposition: when people hear something they don't believe, they are not only often skeptical but adhere even more strongly to their original position. A great deal of psychological research has shown this, but you need look no further than any late-night bar debate you've had with friends: when someone asserts that Sarah Palin is brilliant, or that the Yankees are the best team in baseball, or that Michael Jackson was not a freak, others not only argue the opposing position, but do so with more conviction than they actually hold. We are an argumentative species.

But, can anyone reasonably argue, whether or not they like the data or analysis, that this isn't at least a semi-strong correlation?

I'm guessing Scott may have something to say.

Source: Federal Reserve, BLS