The industrial production (IP) series is like a window into the industrial part of the economy. It differs from most other economic indicators in one important respect. It measures changes in the volume of goods produced. That is, IP doesn’t take the price of these products into account, so there’s no need to worry about the distorting effects of inflation. That makes it a purer measure of output, so it corresponds more closely to the performance of real (inflation-adjusted) GDP. One can ask why IP figures are so influential to economic forecasters when the manufacturing sector makes up less than 20% of the economy, while the service industry gets far less attention yet contributes much more to the economic pie. The answer is that the service sector grows at a fairly stable pace regardless of whether the economy is weak or strong. People will always spend on medical and dental care, transportation, and haircuts. In contrast, manufacturing activity is highly sensitive to changes in interest rates and demand, so it closely parallels shifts in the overall economy. As a result, there is a close relationship between changes in industrial output and GDP growth.
Capacity utilization measures the amount of slack in the economy. If a bike-making firm has the capacity to manufacture 500 bicycles a month but is currently producing only 350, it’s operating at a capacity utilization rate of just 70%. Now let’s assume that the rest of the bike industry is operating at the same low level. Under such circumstances, getting spare parts would be no problem. There’s likely to be lots of extra bike tires and brakes available from suppliers. Nor would there be a reason to hire additional workers or invest in new bike-making machinery, because there are not enough buyers out there to purchase what can already easily be produced.
But all this changes when demand surges and the industry starts churning out bikes at close to 100% of its capacity. If that feverish pace continues for an extended period, bike makers will begin to experience shortages in parts. Prices for bike components can also rise. As the cost of assembling bicycles accelerates, shoppers will see their price tags go up as well. The lesson here is that as American industry gets closer to operating at full capacity, shortages in resources emerge, and this can generate inflation. High-capacity utilization rates can also lead to new investments in factory equipment and plant expansion so that companies can increase output in the future. As you might imagine, the capacity utilization rate for manufacturing typically climbs when the economy is vibrant and falls when demand softens.”
How Is It Computed?
Every month, the Federal Reserve calculates an index of industrial production after collecting data on more than 300 industry components representing manufacturing, mining, and the electric utilities and gas industries. Each component is given a weight based on how important it is to the economy. (These weights are adjusted every year.) Most of this information is derived from government data as well as private trade associations.
The Fed first puts out a preliminary release on industrial production two weeks after the reporting month, and it is based on only 70% of the data needed. Why such a low figure? Because the investment community and policymakers want to get a read on industrial activity as quickly as possible given this sector’s role in the economy and its sensitivity to turning points in the business cycle. Since it takes time to collect output figures from so many industries, some 30% of the information arrives too late for the first report. Fed economists thus fill in the gaps with estimates that are based on other economic reports. These reports include hours worked in factories (from the employment data) and the amount of electric power consumed by businesses (from power-supply companies).
Interestingly, both hours worked and electric power consumption seem to move in line with total industrial output, so these estimates tend to be quite accurate. Indeed, the preliminary IP index and the final revised index three months later vary by an average of just 0.3 percentage points.
Finally, data on IP is presented in two formats. One is by “major market group,” which essentially reflects the demand or consumer goods, business equipment, intermediate goods, and materials. The second format is industry group,” and it measures output by industry in broad, supply-side terms.
One cautionary note: Although industrial production figures are seasonally adjusted, final numbers can occasionally be distorted because of bizarre weather, natural disasters, or a major labor strike. Thus, to discern the true underlying growth rate of industrial production in the economy, it is best to look at a three-month moving average. (Industrial production does not include output from agriculture, construction, transportation, communications, trade, finance, or service industries.)
If you think industrial production is tough to compute, calculating capacity utilization rates is very near a crapshoot. To determine what proportion of capacity is being used, you have to know how much industry is capable of producing when it operates at full speed. However, that is impossible to determine with any precision. For one, how do you define full capacity? Industries rarely work at 100% capacity, though theoretically they can function seven days a week, 24 hours a day. Indeed, some industries do have such nonstop operations. These companies include chemical and steel manufacturers, as well as petroleum refining companies. During times of war, many other U.S. industries mobilize their workforce and plants to work past 90% capacity. However, these are extreme situations. The Fed gets around this by defining capacity based on what is considered the “normal” operating time for each industry. A second difficulty in calculating capacity is that a growing number of production facilities are not even located in the U.S. Though capacity utilization in this report is based only on U.S. operations, the fact is that manufacturing capacity is increasingly being moved offshore, where costs are cheaper. Because American companies can also rely on these foreign production facilities to help meet U.S. demand, it becomes harder to define what true full capacity is. Third, manufacturers regularly invest in new plants and equipment, but it’s not immediately clear whether this is done to expand production capabilities or replace aging and less-efficient equipment. Finally, mergers and acquisitions also impact capacity, because they often lead to a permanent shutdown or sale of redundant production facilities. So trying to figure out the nation’s capacity utilization rate at any given moment is like taking a snapshot of a moving target. Yet despite these difficulties, the Federal Reserve makes a valiant effort to calculate capacity utilization rates for 89 detailed industries (71 in manufacturing, 16 in mining, and 2 in utilities) and then comes up with an industry total.
Excerpt From: Bernard Baumohl. “The Secrets of Economic Indicators: Hidden Clues to Future Economic Trends and Investment Opportunities, 3/e.” iBooks. https://itunes.apple.com/us/book/secrets-economic-indicators-hidden-clues-to-future/id547218470?mt=11