This morning, the Federal Reserve released its report on Industrial Production and Capacity Utilization. Both rose more than expected.

This is a far more important report than the amount of attention it tends to get in the press. Think of the capacity utilization numbers as being the employment rate for real, physical capital. Industrial production measures the total output of all the nation’s factories, mines and power plants.

While manufacturing and mining are not as important to the overall economy as they used to be, they are still very important (especially manufacturing). Since manufacturing is inherently more volatile than services, it plays a big role in determining if the overall economy is in a boom or in a bust.

In November, total industrial production rose by 0.8%, after being unchanged in October. The October number was revised down from a 0.1% gain. That small gain was a significant reason for concern, but the rise this month puts that concern to rest. The consensus of economists was looking for a 0.5% increase in November.

The total industrial production number understates things though. It includes the output of utilities as well as factories and mines. Utility output is often as much a function of the weather (the numbers are seasonally adjusted); therefore, since November was milder than normal, so was demand for electricity.

The most important number is manufacturing production, which rose 1.1% on the month after having been down 0.2% in October (originally reported as a 0.1% decline). Relative to a year ago, total production is still down 5.1% and manufacturing output is down 4.9%, so we still have a lot of ground to make up, but the strong November number indicates that we are very much back on the right track.

Mining output was even stronger than manufacturing output in November. It also fell 0.2% in October, but is down 6.8% from a year ago. Utility output fell 1.8% in November, reversing a 1.7% increase in October, and is down 5.1% from a year ago.

The further up the production food chain, the better the increase in output was in November. However, those areas had fallen harder than production of finished goods. Total production of finished goods rose by 0.4% after a 0.1% decline in October, and is down 4.0% from a year ago. Finished consumer goods production was up 0.3% after a 0.1% increase in October and is down 1.9% year over year. Output of business equipment rose by 0.4% in November after a 0.3% slide in October, and is down 8.1% year over year.

Total capacity utilization rose to 71.3% from 70.6% in October (revised from 70.7%). A year ago, the nation’s factories, mines and power plants were operating at 74.4% of capacity. That was already a low figure. Historically, as shown in the graph below, total capacity utilization of around 80% represents a normal healthy economy (the long term average is 80.9%); if it rises to 85% or above it indicates that the economy is booming and might be in danger of overheating, and thus igniting inflation. A reading of 75% normally indicates recessionary conditions. (See graph below from http://www.calculatedriskblog.com/)

This cycle, we hit a low of 68.3% in June, so the rebound since then has been very significant, but we are still just a little bit higher than we were at the previous record low set in December 1982, at 70.9%.

Even though the PPI came in higher than expected this month, most of that was due to energy prices. It is hard to see how we get a wage-price spiral when unemployment is running at 10% and factories across the country are sitting idle.

Also consider that some of the improvement we have seen is ephemeral — some of our capacity is not only sitting idle, it has been destroyed forever. Total production capacity is down 0.9% from a year ago, which is one way of getting capacity utilization up, but does not really add to long-term economic strength.

As with the Industrial production numbers, the numbers for Manufacturing alone are probably more important than the total numbers, particularly on a month-to-month basis (again the influence of weather). Manufacturing utilization fell even harder than total utilization in this cycle, hitting a low of 65.2% in June. A year ago it was 71.1%, and the long-term average is 79.6%. In November it rose to 68.4% from 67.6% in both October and September.

On the other hand, 1.2% of the manufacturing capacity we had a year ago is not coming back. Mines were also more active in November than in October, with utilization rising to 85.2% from 83.3% in October and creeping back to the year-ago level of 87.9%. The long-term average utilization rate in mines is 90.7%. Thus, we still have some ground to make up, but not as much as in manufacturing. The increase in utilization, though, has been aided by the permanent shut down of 0.7% of mine capacity over the last year.

Utility utilization moved the other way. It fell to 77.9% from 79.4% in October and is down from 83.5% a year ago and a long-term average rate of utilization of 86.8%. Unlike mines and factories, we are actually increasing our utility capacity, by 1.8% from a year ago.

Utilization up the production chain is doing much better than downstream. Utilization of finished goods was just 70.0%, up from 69.4% last month, but is down from 71.2% a year ago and a long term average of 77.7%. Production of crude goods was 85.2%, up sharply from 83.4% in October and actually above the year-ago level of 84.7%. It too has been aided by a 1.2% shrinkage in total capacity.

Still, we are not that far off the long-term average utilization rate of 86.6%. Curiously, the step in the middle — semi finished goods capacity utilization — is actually well below that of either crude of finished goods at 67.8%, up from 67.4% last month, but down from 73.5% a year ago and well off its long-term average of 82.0%.

The much higher utilization rates for crude goods could indicate that we are exporting much more in the way of crude goods, which is not a good long-term sign. We would generally prefer to do the later, higher-value-added stages of production than just producing the raw materials.

The increase in mining activity was primarily in oil and gas production (and related oil field services that are lumped in with mining). This reflects the growing amount of unconventional natural gas coming from the shale plays. As Exxon’s (XOM) purchase yesterday of XTO Energy (XTO) indicates this is a very significant and important development for our long-term energy future. There are many other firms that are active in those shale plays that will benefit, such as Chesapeake (CHK) and EnCana (ECA).  

Overall this was a very positive report, and puts to rest some very serious concerns about the recovery stalling that came along with the weak report in October. This is a big one to put into the “plus” column for the economy.

Since it is expensive to have factories sitting idle, putting them back on line should also be very good for corporate profits — particularly in those firms that actually make stuff. We have a long journey ahead of us, but we are headed in the right direction.


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