Capacity Utilization: Bad times ahead for investment?

Industrial production fell 1.5 percent in February. The fall is bad news but compared with Japan’s 10 percent fall for January released last week, the number was almost heartening. In level terms, IP is now near its lows in the 2001 recession. (Again heartening compared with Japan whose IP is at its 1984 level – anybody remember Foot Loose or Time After Time?)
More interestingly, manufacturing capacity utilization, 67.4 percent, fell solidly below its previous post-war low. This is the largest fall in utilization rates in the series. This number is consistent with the large manufacturing job losses over the past three years.

Total capacity utilization was exactly tied with its previous post-war low of 70.9 percent, achieved in December 1982. This number is boosted by both utilities and mining, neither of which has fallen to any significant degree so far in this downturn. Both series likely benefit from a decline in relative capacity. Nonetheless, I expect mining capacity utilization to fall going forward, as low metals prices is likely to close an increasing number of mines.

That capacity utilization is so low is bad news. It means that between 10 and 15 percent of our factories are idle, relative to normal, expansionary utilization rates. To many (see for example this post at Calculated Risk), the low rate of capacity utilization implies ongoing contractions in business investment. The intuition is simple: if factories are under-utilized today, why would firms invest in new capacity going forward.

And it’s true, falling capacity utilization tends to predict investment contractions. The rate, however, seems to be a good indicator of bad times today and not an independent predictor of bad times in the future.

To see this, take a look at the previous post-war low for total capacity utilization: December 1982.

Despite the record low utilization rates, at the end of 1982, 1983 was the best year, in terms of investment growth on record. This statement is true for both equipment and software spending (shown above) and for nonresidential structures.

Does this mean I am calling the end of the recession? Of course not. I am only making the simple point that low capacity utilization is not inherently linked to low investment. We are still in the midst of the downward leg of this recession. The only good news I see is the occasional lack of bad news. For example, housing starts for February bounced off their January lows. This is good news relative to the decline most people expected; however, it does not signal the end of the housing correction. Inventories are still too high (though adjusting). The economy can’t recover while initial claims for unemployment remain in the 600s.