Schwab Guide To Economic Indicators: Industrial Production and Capacity Utilization

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Schwab Guide to Economic Indicators: Industrial Production and Capacity Utilization
by the Schwab Center for Financial Research
November 30, 2007

What is it?
It's a monthly report produced by the Federal Reserve consisting of (1) industrial production and (2) related capacity utilization rates covering manufacturing, mining, and electric and gas utilities.

What is its relative importance?
High. This is one of several key reports monitored by the Fed in setting monetary policy. According to the Fed, "the industrial sector, together with construction, accounts for the bulk of the variation in national output over the course of a business cycle. The industrial detail provided by these measures [industrial production and capacity utilization] helps illuminate structural developments in the economy." Said another way, movements in industrial production and capacity utilization help explain changes in gross domestic product as the economy experiences ups and downs. The detail helps describe to what extent various industries are participating—up, down, or about the same—as the pace of economic growth changes. It can also shed light on which industries are gaining prominence and which are losing ground.
What impact does it have on the market?
The degree to which industrial production and capacity utilization, along with revisions, meet expectations is typically one of the most influential aspects of the report.

If the trend in industrial production and capacity utilization exceeds forecasts in a way that hints the economy is overheating, bond prices typically fall (yields rise) on the outlook for greater overall economic demand, potentially higher inflation and an increased chance that the Fed will hike interest rates. Stock prices may also fall.

Why?

A rise in bond yields can make bonds more attractive once the fall in bond prices settles down. Compared to where the weights of stocks and bonds were in your portfolio, the typical thing to do in response to this change in valuation would be to sell some stocks and put the proceeds into bonds. Even if corporate profit growth seems supported in this time of strong industrial production and capacity utilization, the market will likely see it as being short lived given expectations for impending rate hikes and eventually slower economic growth.

Alternatively, if industrial production and capacity utilization exceed forecasts during slack economic times, this can give a boost to stock prices. That's because the market's expectation of potentially higher profit growth from greater economic demand can initially be the more influential factor in favor of higher stock prices. That is, for a period of time, it can be the more-dominant driver of stock prices, overshadowing the negative impact of rising bond yields (as discussed above).

How is it calculated?
The level of industrial production is expressed as a percentage of real output (adjusted for inflation) relative to a base year. The base year is 2002 with the level equal to 100. Analysts and economists are typically interested in the percent change of the level from month to month and how it compares with the perceived trend of the economy at that time.

According to the Fed, "the capacity utilization rate is equal to an output index (seasonally adjusted) divided by a capacity index. The Federal Reserve Board's capacity indexes attempt to capture the concept of sustainable maximum output—the greatest level of output a plant can maintain within the framework of a realistic work schedule, after factoring in normal downtime and assuming sufficient availability of inputs to operate the capital in place."

How is it used?
Industrial production is an important input for estimating gross domestic product (GDP), considered to be the most comprehensive measure of overall U.S. economic growth.

That said, when a specific production category experiences an extreme change that doesn't appear sustainable, its impact is usually excluded or tempered by analysts and economists. This is done to get a better sense of the overall trend of industrial production.

A good example is when unseasonably mild temperatures exist during portions of the summer. This can happen during a month that's typically known for robust electrical production because of wide-spread use of air conditioners. In this example, demand for electricity is unusually low. Therefore, it might be better in this situation to view the overall industrial-production trend without the utilities component.

While capacity utilization is also associated with GDP trends, it's primarily used as a barometer of inflation. On the surface, a capacity utilization rate of 100% would seem optimal. Yet 100% capacity utilization rates are considered too tight because they leave no room for absorbing additional economic demand. Such a scenario is considered inflationary. Instead, a rate is sought that leaves some cushion in order to maximize output while keeping inflation contained. In a general sense, that figure is 80%. Yet it can vary by industry.

Capacity utilization rates that consistently come in above trend are considered inflationary, and may cause the Fed to raise short-term interest rates. Alternatively, sub-par capacity utilization rates could be deflationary, and might prompt the Fed to cut short-term interest rates. As with industrial production, capacity utilization trends can be better understood by qualifying extreme, unsustainable changes of a specific category during a given month.

When is it released?
It's released in the middle of the month, usually between the 14th and 17th, and can be found at http://www.federalreserve.gov/. From the Site Map, look for the "Economic Research and Data" section and click on the "Statistics: Releases and Historical Data" sub-section to locate the report.

The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The type of securities mentioned may not be suitable for everyone. Each investor needs to review a security transaction for his or her own particular situation. Data contained here is obtained from what are considered reliable sources; however, its accuracy, completeness or reliability cannot be guaranteed.

(2007-5771)

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