The Long-Term Worries of Capacity Utilization Under 80%

One report that rarely receives enough attention is the Federal Reserve’s monthly report on capacity utilization. The industrial production numbers tend to be more volatile and can fluctuate, but the report on capacity utilization intends to show through time a picture of how employers are running their shops, factories and operations. While this ties in with today’s report, we are most concerned with the longer-term issues that this poses.

Today’s report showed a 0.4% production gain, versus a 0.2% gain expected. Capacity utilization also came in as expected at 78.3%. The problem is that this capacity reading is dismal, and it shows that the core economy is not running well even though this is nearly a peak report for the cycle.

The theory is simple enough. If capacity is running low, final demand is low and the need to massively hire workers is low. Of course there are exceptions, and nonfarm productivity can be taken into consideration as well. Still, if businesses are running at low capacity rates, then there is little reason to expect waves of hiring from the nonfarm sector.

It used to be that anything under 80% was a disappointment in capacity utilization. Now 80% would be a dream come true. A detailed table from ForecastChart.com shows the capacity utilization rates (rounded to the closest number) going back over 40 years. During the peak of the recession, capacity dipped under 70% for 11 consecutive months. The problem is that capacity has just not caught back up and it has yet to go over 80% in any month since the end of the recession.

One value investing portfolio manager once told us that he is most concerned about low capacity utilization rates. If capacity is low here and under par elsewhere for long periods, then end demand is just not there for anything that would feel like an economy that is firing on all cylinders. Imagine a world awash in capacity. The translation is, “We are here and open for business, but we need more orders.”

Bloomberg says about capacity utilization: “The capacity index, which is an estimate of sustainable potential output, is also expressed as a percentage of actual output in 2007. The rate of capacity utilization equals the seasonally adjusted output index expressed as a percentage of the related capacity index.”

Capacity has all sorts of ramifications for the economy. It considers many industries, it is another measurement of the need to hire, and it speaks loudly about overall demand and consumption. If this economy is ever going to feel that good again we need to get the old capacity rates back to a floor of 80% rather than a ceiling being under 80%.

JON C. OGG