Wednesday, January 16, 2008

Another Nail


Eight times per year the Federal Reserve publishes an anecdotal summary of economic activity known as the Beige Book. Today’s report ( began as follows:

“Reports from the twelve Federal Reserve Districts suggest that economic activity increased modestly during the survey period of mid-November through December, but at a slower pace compared with the previous survey period. ….

“Most reports on retail activity indicated subdued holiday spending and further weakness in auto sales. However, most reports on tourism spending were positive. Residential real estate conditions continued to be quite weak in all Districts. Reports on commercial real estate activity varied, with some reports noting signs of softening demand. Manufacturing reports varied across industries, with pronounced weakness noted in housing-related industries as well as the automobile industry. Strong export orders and increased demand in industries whose products compete against imports was reported by some Districts. Demand for nonfinancial services remained generally positive, although some Districts commented on continuing weak demand for transportation services.”

Not so robust………..

And another Federal Reserve report released today indicates industrial activity has peaked, probably reached an inflection point and will begin heading south soon. Industrial production was flat in December and capacity utilization declined slightly (

Industrial production measures the output of the mining, manufacturing and public-utility sectors. Capacity utilization asks and answers the following question, “What is the current level of industrial production measured as a percentage of the maximum?” If the maximum output an industry can produce with its current plant and equipment is 100 tons of product a day, and it is currently producing 80 tons of product a day, then that industry is operating at 80% of capacity. Note that capacity utilization compares the level of productive capacity with the actual level of output. Both grow over time. If the percentage is rising, that means industrial production is gaining more rapidly than industry is adding new plant and equipment (productive capacity).

See the chart below for capacity utilization’s record.

Capacity Utilization

(Click on chart to enlarge)

Recessions shaded

The Fed’s latest report reveals that productive capacity (the amount of plant and equipment in place) rose by 1.8% in 2007 and industrial production grew by 1.5%. Both numbers are weak, but the fact that productive capacity increased more rapidly than production is of greater interest. As a result capacity utilization fell by 0,2% in 2007. That’s not much, but (as the chart above reveals) it’s the first time in the recent five-year expansion that capacity utilization has not risen year-over-year. That’s probably an inflection point and production will most likely begin to fall.

More import……… The fact that productive capacity rose while production stalled means that industry will now stop adding more capacity. Why add additional plant and equipment when the utilization rate for the existing stock is falling? Why add more factories and machinery when you’re using the present facilities at a slower pace? And that decision – to cut back on capital expenditures – can only make a bad situation worse. It means that the capital-goods industries will soon follow the construction-related industries south.

(The chart was taken from [Click on Seminars and then Charts.] Go there for additional charts on the economy and a list of Economic Indicators.)

© 2008 Michael B. Lehmann

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