Over the weekend, I spent some time cleaning the garage. We use a storage site nearby and I was moving summer equipment to make room for winter equipment. While there, I noticed that the storage site is constructing 120 new units. I ran into the owner of the facility as I was unloading and asked him how the rentals were going. He told me that they were all rented before construction was complete, and at the price he wanted. He is thinking about building more. That suggests to me that there is no excess capacity in our area and reminded me about the link between capacity utilization and prices.
Capacity Utilization
Last week, the Federal Reserve released some information about the U.S. economy’s capacity utilization and industrial production (these numbers are released together). It noted that “capacity utilization for the industrial sector edged up 0.1% in September to 75.4%, a rate that is 4.6 percentage points below its long-running (1972-2015) average.”
In addition, the Fed noted that industrial production was up an annualized rate of 1.8% during the third quarter, the first quarterly increase since the third quarter of 2015. Digging a little deeper into the numbers we can see that the strength came from a rebound in construction and nonindustrial supplies during September (up .8% and .7%) while there was continued weakness in materials and business equipment (down .2% each in September). In fact, these two areas along with mining, have the worst year-over-year declines (down 1.4%, 2.2% and 9.4% respectively).
This information provides additional evidence that our economy is growing, albeit at a very slow rate. If the economic recovery was strengthening you would expect to see a pick-up in business equipment because it would indicate that companies are investing more in themselves. Instead, the slow rate of economic growth is causing companies to postpone investments in favor of maintaining higher cash positions. This can be seen in one of the capacity sub-groups, Machinery. The capacity utilization of this group was 71.5% in September. That is 6.2 percentage points below the long-run average and 16.4 percentage points below the mid ‘90s peak. Companies are not investing as much in machinery due to the slow growth economy. When the economy grows slowly, not only do businesses invest less, they must wrestle with unused capacity because it has a cost. Unused capacity can have a deleterious effect on companies’ profitability.
We can contrast that with an industry that has been running well, the auto industry. The Motor Vehicles and Parts sub-group was at 84.5% capacity in September, almost 10 percentage points above its long-term average and only 3.3 points from the all-time high. We know the auto industry has been doing well, a reflection of a strong consumer sector. The contrast between Machinery and Autos provides some insight into the useful nature of the capacity numbers.
Inflation
Last week, the consumer price index (CPI) was released and showed that inflation grew by .3% in September. The core rate of inflation (excluding food and energy) grew by .1%. Over the last 12 months, the index grew by 1.5% and the core rate grew by 2.2%. However, a big part of that increase was from the rise in gas prices. The gasoline index grew by 5.8% and accounted for more than half of the increase in the CPI. Of course we know that oil prices have risen in recent weeks, accounting for the rise in gas prices. However, this increase seems to have stabilized and we don’t expect it to move much higher.
The reason we monitor inflation is because it influences interest rates. When inflation moves higher, in a normal economic environment, the Federal Reserve acts to raise interest rates and tries to cool the economy. However, this isn’t a “normal” environment. In fact, the week before last, the Fed Chair, Janet Yellen, spoke about allowing the economy to run hotter, i.e. more inflation, because growth is so slow. So while The Fed’s target for inflation is 2%, it has indicated that it would be OK if inflation was higher than that for some time because the economy could use a boost of growth.
Once again, this may be a case of the Fed “talking its book” rather than acknowledging what is really happening. It would like to see more inflation because it would likely mean that the economy’s performance is improving. That doesn’t seem to be in the cards near-term.
The low rate of capacity utilization, particularly in parts of the economy that would reflect a pick-up in business activity suggests that the inflation rate has mostly risen due to the higher price of oil and housing — neither of which have risen due to a substantial increase in demand. (Housing inflation is a rent equivalent and rents have been rising due to a shortage of inventory – a topic for another week.) That means that those price increases could be transitory which would suggest that the Fed won’t get its desired growth in the economy or inflation during the next twelve months. If that is the case, then lower interest rates will be with us for an extended period.
Thinking about the owner of the rental storage provider in my area, he was able to rent all of his new units, at the price he desired, indicating that excess capacity doesn’t yet exist. The link between pricing and capacity utilization is an important one.
