Total Industrial Production fell 0.1% in January, which was well below the expected 0.6% increase. While on first blush the decline and the miss are big disappointments, if one digs deeper, it really was not a bad report.
The increase comes after a 1.2% rise in December, and that was revised up by 0.4% from 0.8%. Thus relative to where we thought industrial production was in December, output is actually up, not down. In November, total production increased by 0.3%, and was not revised. Relative to a year ago, total Industrial Production is up 5.2%. In normal times, that would be great growth, but for coming out of a deep recession, it is a bit on the weak side.
Weather Affects
Total Industrial Production includes not only the output of the nation’s factories, but of its mines and utility power plants as well. The production and consumption of electricity generally has as much to do with the weather as it does with overall economic activity. December was much colder than most Decembers, at least in the U.S. and thus a higher than normal demand for electricity. January, while cold, was closer to a normal January than December was.
Thus it is important to look at just how the manufacturing sector is doing alone. It rose 0.3% in January, down from December’s 0.9% increase and matching November’s increase. However, the December numbers were revised up sharply, from an original report of just a 0.4% increase. Year-over-year factory output was up 5.5%.
Utility output fell by 1.6% after surging by 4.1% in December, on top of a 2.1% increase in November, but that was after plunging 4.3% in October. Year-over-year Utility output was up 0.1%. The utility number is mostly about weather, not changes in economic activity, and can be very volatile. The manufacturing-only number is a better gauge of overall economic activity.
The third sector tracked by the report is Mining (including oil and natural gas). The output of the nation’s mines fell by 0.7% in January after it rose by 0.5% in December but after a 1.0% decline in November. Year-over-year mine output is up 7.5%.
Stages of Production
By stage of production, output of finished goods rose by 0.4%, on top of a 1.0% increase in December. Relative to a year ago, finished goods production is up 4.7%. Finished goods are separated into consumer goods and business equipment, and there is a real dichotomy between the two.
Consumers are trying hard to rebuild their balance sheets. That means spending less on current consumption while paying down debt and building up savings. That is a tough thing to do when you are unemployed, but the 91.0% of people who are working are doing their best to get their personal fiscal houses in order.
In addition, a large part of consumer finished goods are imports, not made here in the U.S. Output of finished consumer goods edged up by 0.1%, but that was after an increase of 1.0% in December and a 0.3% decline in November. Year over year, output of consumer goods is up just 2.2%.
Business equipment output, on the other hand, has been consistently strong, rising 0.9% in January after being up 1.0% in December and after rising 0.3% in November. Business equipment production is up 11.4% from a year ago.
Business investment in Equipment and Software has been one of the strongest parts of the economy, contributing 0.41 points of the 3.20% total growth in the economy in the fourth quarter, even though it makes up just 7.21% of GDP. That, however, was a big slowdown from the third quarter when it added 1.02 points of the 2.60 points of total growth. It looks like it will be another strong contributor in the first quarter as well.
Output of materials fell 0.4%, but that was after a 1.5% increase in December (revised up from a 1.0% increase. In November, materials output rose by 0.4%. Materials output is up 6.2% year over year. The first graph (from http://www.calculatedriskblog.com/) below shows the long-term path of total industrial production (blue) and manufacturing-only industrial production (red).
As manufacturing output is the bulk of total output, it is not surprising that the two lines track pretty well with each other over longer periods of time. While we are in much better shape than we were a year ago, production is still well below pre-recession levels. That is not particularly unusual a year and a half after the end of a recession; it usually takes at lest two years after production bottoms to reach a new high. In the Great Recession it fell much more than it had in any previous downturn.
Capacity Utilization
The other side of the report is Capacity Utilization. This is one of the most underappreciated economic indicators out there, and one that deserves a lot more attention and ink than it usually gets. Total capacity utilization suffers from the same weather related drawback as does Industrial Production. That served to restrain it this month.
Total Capacity Utilization fell to 76.1% from 76.2% in December. However, December was revised higher by 0.3%. Thus the decline is all a function of the starting level being higher than we thought. The revival of capacity utilization has been going on for more than a year now. A year ago, just 72.3% of our overall capacity was being used, and that was up from a record low of 68.2% in June 2009.
The basic rule of thumb on total capacity utilization is that if it gets up above 85%, the economy is booming and in severe danger of overheating. This is effectively raises a red flag at the Fed and tells them that they need to raise short-term interest rates to cool the economy. It is also a signal to Congress that it is time to either cut spending or raise taxes, also to cool down the economy (Congress seldom listens to what capacity utilization is saying, but the Fed does).
Capacity utilization of around 80 signals a nice healthy economy — sort of the “Goldilocks” level — not too hot, not too cold. The long-term average level is 80.5%. A level of 75% is usually associated with a recession. The Great Recession was the only one on record where it fell below 70%.
Thus a 7.9% improvement in overall capacity utilization from the lows is highly significant and very good news. On the other hand, we still have a very long way to go for the economy to be considered healthy. The second graph (also from http://www.calculatedriskblog.com/) shows the path of capacity utilization (total, and manufacturing) since 1967.
Note that the previous expansion was sort of on the pathetic side when it came to capacity utilization, barely getting over the long-term average at its peak, the previous two expansions both hit the 85% overheating mark (the 1990s doing so on two separate occasions).
Factory utilization rose to 73.7% in January, up from 72.5% in December (revised up from 73.2%) and from 72.9% in November (unrevised). That is up from 69.8% a year ago, and the cycle (and record) low of 65.4% in June 2009. That is still well below the long-term average level of 79.1%, so as with total capacity, we still have a long way to go on the factory utilization level.
Total capacity and manufacturing capacity were unchanged from a year ago. For most of the last two years we have seen year-over-year declines in capacity. While shrinking capacity makes it easier to use the remaining capacity at a higher level, it is not a good sign for the economy. Being back to unchanged is a good first step.
Mining
Mines were working at 88.1% of capacity in January, down from 88.8% in December and down from 88.5% in November. That might be a bit of a yellow flag, but only of it proves to be the start of a trend. A year ago they were only operating at 82.2% and the cycle low was 79.6%. We are actually now above the long-term average of 87.4% of capacity.
Since there is a lot of operating leverage in most mining companies, this probably means very good things for the profitability of mining firms with big U.S. operations like Freeport McMoRan (FCX) and Peabody Energy (BTU). Mine capacity increased 0.3% year over year. As depreciation is more than just an accounting exercise when it comes to mining equipment, the high operating rates are also good news for the equipment makers like Joy Global (JOYG).
Utility utilization fell to 81.2% from 82.8% in December but up from 79.6% in November. We are still below the long-term average utilization of 86.5%. Increasing utility utilization faces a headwind because, unlike factories, our power plant capacity has actually been increasing significantly, up 1.5% year over year.
The weather-related changes in utility utilization is a significant distorting factor in the overall figures for both utilization and production figures. In assessing the state of the overall economy, it is better to just look at the manufacturing numbers. In January, including the Utilities made things look soft; when the weather-related affects of the Utilities are removed, it was a fairly solid report.
That is particularly true if you consider the upward revisions to the December numbers. The upward revision to December’s production and utilization numbers suggests that when we get the next look at fourth quarter GDP it will be revised up, perhaps closer to 3.4% than the current estimate of 3.2%.
Stages of Processing
By stage of processing, utilization of facilities producing crude goods (including the output of mines) fell to 88.6% from 89.4% in December and from 88.3% in November. Both previous months were revised upwards, December by 0.4% and November by 0.1%. A year ago, crude good facilities were operating at just 82.6% of capacity, and the cycle low was 78.3%. We are now above the long-term average of 86.4%. On the other hand, capacity has declined by 0.5% over the last year.
Utilization for primary, or semi-finished goods fell to 73.2% from 73.5% in December, but is up from 72.3% in November. December was revised up from 73.2%, so in that sense, utilization was unchanged. November was revised up from 72.1%. While that is much better than the 69.7% level of a year ago, and the cycle low of 65.7%, it is a very long way from the long-term average of 81.3%.
Still, the trend is in the right direction. Primary and semi-finished capacity though is down by 0.4% year over year.
Utilization of facilities producing finished goods rose to 74.7% from 74.4% in December and 74.1% in November. December was revised up from 74.3% but November was revised down from 74.2%. It is up from 72.0% a year ago, and a cycle low of 67.5%. It also remains below its long-term average of 77.4%, but we are getting closer.
Interestingly, our capacity to produce finished goods has actually increased by 1.2% over the last year, so the rise in utilization there is facing a headwind, not a tailwind. Part of that is due to Utilities, since electricity is considered a finished good.
Deceptively Good Report
Overall, this report was deceptively good. The headline looks weak, but that is all due to the Utility segment, and two big upward revisions to the December data. Once that is accounted for, it seems clear that we are headed in the right direction, but still have a long way to go.
Factory output and capacity utilization is still rising. The low levels of capacity utilization are one of the key reasons that inflation has remained low, and is not much of a threat in the intermediate future.
This gives the Fed free reign to not only keep short-term interest rates at extraordinarily low levels for an extended period of time (probably until at least the end of 2011) but to take even more aggressive steps to ease monetary conditions, such as QE2. While under ordinary circumstances doing so would raise a big threat of inflation accelerating, we do not live in ordinary times. Right now the bigger threat is deflation, not runaway inflation. Or at least it is in the absence of QE2.
While the economy is recovering, it is still running at levels far below its potential. The capacity utilization numbers can be thought of as sort of like the employment rate on physical capital, much like the employment to population rate is the employment rate for human capital. Both are running well below where we want them to be.
While additional monetary stimulus would be useful at the margin, the cost of capital is not the major issue right now, it is lack of aggregate demand. As such, additional fiscal stimulus would be much more effective in getting the economy going again. While the recent tax deal is not the most efficient stimulus on an impact-per-dollar-spent basis, it should help increase growth in 2011.
Getting the economy back into high gear would also start to raise tax revenues, and so the net cost of additional stimulus should be less than the advertised amount. Of course, the two are not mutually exclusive, and the economy would benefit from both being used.
Unfortunately, that is not the direction the debate is going, it is about how much we are going to cut spending in the short term. We have been seeing anti-stimulus from the State and Local level throughout the Great Recession, and it is the total amount of fiscal stimulus that counts for the economy, not just what happens at the Federal level. De-stimulus from the lower levels of government has offset about half of the Federal Stimulus we got from the ARRA.
The combination of QE2 and the tax compromise will help growth at the margin in 2011, but we still face some pretty serious headwinds. The main stimulus from both QE2 and the tax deal will wear off at the end of 2011, but hopefully the economy will be self sustaining at that point (hopefully being the operative word). If the we are going to counter the effects of the tax deal by drastic spending cuts, then not much good will have been done in getting the economy moving forward at a faster rate.
The attempt to cut spending now, as in the proposed cuts of $60 billion for the rest of fiscal year 2011, is deeply misguided. The U.K. has gone down that path, and the net result was that its economy fell by 0.5% in the fourth quarter.
We have taken a moderately stimulative path with overall fiscal policy (stimulus at the Federal Level offset by austerity at the State and Local level) and grew by 3.2% (and very high quality growth) in the fourth quarter. Budget cuts that end up slowing the overall growth of the economy will slow the recovery in tax revenues and will result in much less progress on cutting the deficit than is advertised.
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