FRBSF Economic Letter
96-34; November 15, 1996
Capacity Utilization and Structural Change
The Federal Reserve Board's measures of capacity utilization for the
U.S. manufacturing sector have been a useful indicator of inflationary
pressures. However, some observers have claimed that the relationship
between capacity utilization and inflation has broken down recently, owing
to increased international trade, a shift in the share of the nation's
workforce in service-producing industries, and rapid technological change.
This Economic Letter, which draws on Corrado and Mattey (1997),
reviews the evidence for this claim and finds it largely unsupported by
the facts. Although there have been some structural changes in the U.S.
economy, the basic indicator value of capacity utilization for inflation
has endured.
What is capacity utilization?
Capacity utilization for an individual manufacturing plant is the ratio
of the plant's actual output level to its potential or capacity output
level. Capacity output is a measure of the extent to which the manufacturing
plant can produce goods, given its current technology and fixed factors
of production (such as the capital stock).
The Federal Reserve publishes monthly indices of capacity utilization
for a wide range of manufacturing industries. Each industry utilization
rate is the ratio of an industrial production index to a related index
of capacity output. Short-run movements in industrial production are the
primary source of changes in utilization rates, but the Fed utilization
measures also reflect the year-to-year evolution of capacity.
The primary source of information on capacity changes is the Census
Bureau's Survey of Plant Capacity. The survey method has the
advantage of allowing respondents to incorporate in their estimates a
broad range of capacity determinants, such as technological changes.
Capacity utilization and inflation
There are some microeconomic underpinnings to the aggregate relation
between overall capacity utilization and inflation. With a perfectly competitive
market structure, an increase in capacity utilization at a manufacturing
plant will tend to be associated with an increase in its output price,
assuming that output is increasing because the demand curve has shifted
outward along an upward-sloping supply (marginal cost) curve. However,
evidence from micro-data has neither been able to confirm nor refute such
a structural interpretation of the relationship between capacity utilization
and price changes.
On the other hand, evidence from macro-data does provide support to
the idea that increases in aggregate demand increase inflationary pressures.
In macroeconomic models, the relationship between resource utilization
and inflation generally is embodied in multiple equations. For example,
in a two-equation wage-price subsystem, a (Phillips-curve) wage equation
may relate the excess of wage inflation over expected price inflation
to the unemployment rate, and a (markup) price equation may relate the
excess of price inflation over wage inflation to capacity utilization
or another measure of product market slack, such as the gap between actual
and potential GDP. If capacity utilization is made to do the double-duty
of reflecting both product and labor market slack, the two equations can
be combined into a single reduced-form price equation with a single measure
of resource utilization as an explanatory variable. Note, however, that
well-specified models of inflation also will include many other explanatory
factors.
In other words, even the most basic macroeconomic model does not suggest
that overall inflation should be highly correlated with capacity utilization
without controlling for other factors. Indeed, the correlation between
the level of inflation and utilization is weak, reflecting the important
role of long-term monetary policy influences, short-run food and energy
price shocks, and other inflation determinants which belong in fully specified
models of inflation in addition to measures of resource utilization.
Lagged inflation rates can be used to proxy some of the longer-run determinants
of the underlying inflation rate, such as long-term monetary policy effects.
In fact, statistical analysis reveals that last year's inflation rate
is a decent approximation to these longer-term inflation influences. Accordingly,
capacity utilization is related more strongly to the acceleration
of inflation than to the level of inflation. Also, to keep matters simple,
most of the effects of food and energy price shocks can be controlled
for by focusing on the acceleration in the core measure of the CPI, which
excludes the prices of food and energy items. As illustrated in Figure 1, capacity utilization has a
relatively strong correlation with the acceleration of core consumer price
inflation.
Relation to (un)employment
Though only directly measuring the relative level of activity in the
industrial sector, capacity utilization also tends to reflect the state
of the broader economy. This shows up in a high correlation between capacity
utilization and the jobless rate. Figure 2 shows standardized (mean zero,
unit variance) measures of the percent of the labor force employed (that
is, 100 minus the unemployment rate) and manufacturing capacity utilization.
Much of the time, both measures convey the same qualitative signal about
the extent of resource utilization.
However, capacity utilization has the advantage of being somewhat more
stable than other commonly used cyclical indicators of inflationary pressures.
Note that the (un)employment rate has experienced more persistent deviations
from its mean than has capacity utilization. For example, in each of the
thirteen years from 1975 to 1987, the unemployment rate remained above
its 5-3/4 percent post-war mean. Yet, inflation did not decelerate throughout
this period; rather, it accelerated sharply in the late 1970s when capacity
utilization rose well above its 82 percent post-war mean. Unless the estimates
of the non-accelerating inflation rate of unemployment (NAIRU) are allowed
to vary over time, capacity utilization retains a slight advantage over
the unemployment rate as a simple predictor of the acceleration
of inflation. This slight advantage of capacity utilization reflects the
long-run stationarity of capacity utilization. That is, capacity utilization
tends to return to the same mean level over time, while the trend unemployment
rate and the estimates of the rate of unemployment consistent with stable
inflation tend to change.
Based essentially on the simple relationship shown in Figure 1, many researchers have found
that for each percentage point capacity utilization exceeds 82 percent,
inflation tends to accelerate by about 0.15 percentage points. Although
the 82 percent figure for the non-accelerating inflation rate of capacity
utilization is estimated imprecisely, with a 95 percent confidence interval
that ranges from about 78-1/2 to 83-1/2 percent of capacity, similarly
wide confidence intervals must be attached to estimates of the non-accelerating
inflation rate of unemployment.
Recent evidence
The relative stability, but somewhat imprecise nature, of the relationship
between capacity utilization and inflation acceleration can be seen in
the most recent historical experience. Capacity utilization peaked at
about 84-1/2 percent at the end of 1994, in the range typically associated
with a slight acceleration of core inflation. Although core inflation
slowed a bit that year, the prediction error was not large, relative to
the historical fit of the simple relationship between capacity utilization
and inflation acceleration. In 1995, capacity utilization edged down to
an operating rate more clearly consistent with neutrality of inflation
pressures, and core inflation was little changed. In the first eight months
of 1996, manufacturing capacity utilization averaged 82 percent, which
is neutral with respect to inflationary pressures. Although core inflation
did slow about 1/2 percentage point at an annual rate in the first eight
months of 1996, a prediction error of this size or larger is relatively
common in a stripped down model which relates core inflation acceleration
only to the level of manufacturing capacity utilization. As indicated
above, the simple relationship between capacity utilization and the acceleration
of core inflation is relatively imprecise, so the events of 1996 are not
necessarily evidence of recent instability.
Structural change and capacity utilization as
an indicator of inflation
The relative stability of capacity utilization as an inflation indicator
spans an era of large structural changes in the U.S. economy. This finding
runs counter to some observers who suggest that "globalization,"
the shift of employment to the services sector, and rapid technological
change should have altered the relationship substantially. For example,
with the significant expansion of international trade over the past 35
years, some commentators have opined that goods prices are now set in
international markets---thus a measure of the domestic capacity to produce
is no longer useful as an inflation indicator. That logic leads them to
the conclusion that, in monitoring inflation, global resource utilization
measures be substituted for domestic capacity utilization.
However, the increased openness of the U.S. economy has not diminished
the usefulness of domestic capacity utilization for predicting inflation.
For one, although foreign penetration of domestic markets has grown substantially,
the proportions are still fairly small for most industries. Second, although
slack capacity abroad will lower local currency prices of foreign goods
and help slow foreign inflation, other factors---changes in the exchange
rate and the extent to which changes in foreign prices are passed through
to prices of goods supplied to the U.S. market--also influence the dollar
price of U.S. imports.
Furthermore, despite the relatively increased importance of the domestic
service sector in recent decades, the predictive power of factory operating
rates for inflation has endured for a couple of reasons. First, capacity
utilization in manufacturing is indicative of the cyclical state of overall
aggregate demand. Fluctuations in the goods and structures component of
GDP account for most of the variation in total output. Moreover, changes
in factory output are highly correlated with changes in this segment of
final demand. Second, capacity utilization is a correlate of cyclical
activity in labor markets. This correlation exists largely because most
of the economy's cyclical employment adjustments occur in the sectors
facing variable aggregate demand, the sectors producing goods and structures,
not services.
Finally, recent technological changes have not diminished the usefulness
of capacity utilization for predicting inflation. In this regard, the
critical question concerning the reliability of the FRB capacity indexes
is whether the productivity gains from the adoption of advanced technologies,
such as flexible manufacturing techniques, are adequately captured in
the survey-based estimates of capacity. Studies of the individual survey
responses on why capacity has changed suggest that investments in flexible
technologies and the like are recorded by respondents as increases in
capacity (Mattey and Strongin 1995). The productivity gains that result
from their use appear in both the numerator and denominator of utilization
measures.
In sum, recent changes in the structure of the U.S. economy do not appear
to have altered the basic relationship between capacity utilization and
inflation.
Joe Mattey
Senior Economist
References
Corrado, C., and J. Mattey. 1997. "Capacity Utilization."
Journal of Economic Perspectives. Forthcoming, Winter.
Mattey, J., and S. Strongin. 1995. "Factor Utilization and Margins
of Output Adjustment." Federal Reserve Board FEDS Discussion Paper
95-12, March.
Opinions expressed in this newsletter do not necessarily reflect
the views of the management of the Federal Reserve Bank of San Francisco,
or of the Board of Governors of the Federal Reserve System. Editorial
comments may be addressed to the editor or to the author. Mail comments
to
Research Department
Federal Reserve Bank of San Francisco
P.O. Box 7702
San Francisco, CA 94120
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