Too Much Capacity

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.