Industrial Production
Despite the snow storms in February, the total industrial production of the country managed to edge up by 0.1% over January. This marked the 8th straight increase in the Industrial Production, but it was also the smallest since it started to increase.
Prior to June, total industrial production had declined for 17 of the previous 18 months, with seven of those months posting declines of more than 1.0% and including one month where production plunged 4.0%.
February marked a major deceleration from the 0.9% increase in January. In December, total industrial production rose 0.5% (revised down from the original estimate of 0.7%). The increase was also slightly better than the consensus expectation that it would be unchanged.
Year-over-year total industrial production is up 1.7%. Total industrial production not only measures the output of the nation’s factories, but of its mines and utilities as well. That is a very significant detail to understand in the report, and also a cause for concern. Manufacturing production actually fell 0.2% in February, after the 0.9% increase in January and a 0.2% decline in December. Having manufacturing output decline in two of the last three months is not exactly a sign of a booming recovery.
In December, total output was able to rise even as factory output fell due to a huge jump in utility output, which surged 5.5% that month. Utility output then rose 0.6% in January and 0.5% in February. In February, what turned a decline in factory output into an increase in total output was a 2.0% rise in mine output. Mine output includes oil and natural gas production as well as coal and hard rock mining.
Utility output is often as much of a function of the weather as it of economic activity. While total industrial production and manufacturing production generally move together, as a gauge of economic activity manufacturing output is what should be watched. On the other hand, it is possible that snowstorms might have affected factory output. If so, we should see it snap back in March. If it doesn’t it would be an indication that the recovery is starting to fade.
Year-over-year factory output is up 1.5%, slightly lower than the 1.7% increase in total output. Utility output is up a very strong 4.4%, but much of that might be weather related. Year-over-year mine output is up just 0.2%.
Capacity Utilization
The second part of the report is on capacity utilization. Overall capacity utilization edged up to 72.7% in February from 72.5% in January and 71.8% in December (both of which were revised down by 0.1%). This is the 8th straight increase in capacity utilization, and it is now well above the year-ago level of 70.6%. It was also better than the 72.3% level expected by the consensus of economists.
However, doing better than a year ago is not saying that much since back then it was the all-time record low. That record was broken each month until things started to turn around in June.
The rule of thumb is that a good healthy economy will be operating at about 80% of capacity. If it gets up above 85%, it is a sign that the economy is going to over heat and policy makers should be very worried about inflation accelerating. A level of 75% is usually associated with a deep recession. During the Great Recession we hit a low of 68.3%.
In other words, we have had a nice rebound off the lows, but we are still at levels as bad as anything ever seen (post WWII) prior to this downturn. Thus, while the direction is very good, the level is still just plain awful.
Think of the capacity utilization rate as the employment rate for physical capital. Like the employment rate, it will never hit 100% — after all, sometimes plants or equipment within them are shut down for maintenance or to retool for the next year’s models. However, a rate of just 72.7% indicates lots of slack in the system, just the way that a 9.7% official unemployment rate shows lots of slack in the system.
This is a key reason why the Fed should keep short-term interest rates very low for a long time to come. We need to see overall capacity utilization move up into the high 70’s before there is a real need to be much tighter on monetary policy.
Breaking Down Capacity Utilization Numbers
Like Industrial production, the overall capacity utilization figures include both mines and utilities. The utility numbers are subject to weather distortion.
Capacity utilization in manufacturing actually ticked down to 69.0% from 69.1% in January and 68.4% in December. The January number was revised down from 69.2%. However, it is a solid improvement over the year-ago level of 67.1%. However, it is well below the long-term (1972-2009) average of 79.2%. The rebound has been aided by a permanent shrinking of capacity as well, by 1.2% overall and by 1.4% in manufacturing. That is hardly a healthy situation.
While far too many factories are sitting idle, the nation’s mines and power plants are operating at much more normal rates. Capacity utilization of mines jumped to 88.2% from 86.4% in January and 85.5% in December, and is now above both the year-ago level of 87.1% and of the long-term average level of 87.5%. That is only partly due to a 1.0% reduction in total capacity over the last year.
The relatively high level of capacity utilization in the mining industry is very good news for the firms that supply equipment to the mines like Joy Global (JOYG) and Bucyrus (BUCY). Remember that mine output includes oil and gas production, so the higher operating rates are also good news for firms in the oil service industry like National Oilwell Varco (NOV) and Baker Hughes (BHI).
Utilization of the nation’s power plants rose to 83.1% from 82.8% in January and 82.5% in December, and 81.1% a year ago. However, it remains well below the long-term average of 86.6% (but nowhere near as big a gap as in manufacturing). Unlike factories and mines, overall capacity in utilities is actually growing, with total capacity rising by 1.9% year over year. The increase in alternative energy sources has not been matched with a permament shut down of older, mostly coal-fired, power plants.
Stages of Processing
Another way of looking at capacity utilization is by stage of processing. Plants producing crude goods have held up much better than those which produce semi-finished or finished goods. Crude goods were operating at 86.2% of capacity in February, up from 85.3% in January and 84.8% in December, and well above the 81.7% level of a year ago. More significantly, they are almost in line with the long term average of 86.5%.
True there has been a bit of help from the shut-down of 1.5% of capacity on a permanent basis, but it is still a fairly impressive recovery. By comparison, plants the next step up the line, which produce primary or semi-finished goods, were only operating at 69.6% of capacity, although that has been trending upward as well, from 69.4% in January and 69.0% in December. It is also up from 68.5% a year ago, but capacity dropped by 1.2%. This explains most of the year-over-year increase in utilization.
Finished goods utilization looks much more like semi-finished than it does crude utilization. It actually dropped slightly to 70.8% from 71.0% in January, but is up from the 70.0% level of December and the year ago level of 68.6%. However it is far below the long-term average rate of 77.5%.
In Summation
If not for the fact that expectations were set low (partly due to the snowstorms), this would have been a disappointing report. It signals that the recovery is losing some of its momentum. The weather-induced distortions mean that the March report will take on extra importance to help determine how much of the slowdown was really weather-related, and how much was a real slowdown in economic activity.
Capacity utilization is a greatly underappreciated economic indicator. As the graph below (from http://www.calculatedriskblog.com/) shows, the turn in capacity utilization almost always marks the end of a recession. Note how much lower capacity utilization was at the top of the last expansion than it had been at the top of every previous economic expansion.
One of the big questions going forward is: what sort of level of capacity utilization will we achieve in this cycle? Will we get back well above 80%, and hit 85% as we had in every economic expansion during the last third of the 20th century (unfortunately, the capacity utilization numbers only go back to 1967, but it is safe to infer from other data that utilization did regularly top 85% in pre 1967 expansions as well). Or will be top out at the 80% level like we did last time, or is the new normal even lower than that?
One weather distorted month does not make a trend, but we really need to see a consistent increase in capacity utilization, particularly in manufacturing, if this economy is ever going to get back to full health. So far, the rebound has been sharper than it was following the last two downturns, which is encouraging, but then again, the decline was steeper than anything we have seen since the mid 1970’s.
That rapid recovery has been one of the most encouraging things about this recovery, and any faltering is a reason for serious concern. The March data should be very significant.
Dirk van Dijk, CFA is the Chief Equity Strategist for Zacks.com. With more than 25 years investment experience he has become a popular commentator appearing in the Wall Street Journal and on CNBC. Dirk is also the Editor in charge of the market beating Zacks Strategic Investor service.
