The full text on this page is automatically extracted from the file linked above and may contain errors and inconsistencies.
§©, l i l l I F IT'@\lill(C
li
iSJ)
April 13, 1984
Inflation and Capacity
Recent economic strength has been greater
than most analysts had anticipated.
According to the Commerce Department's
flash report, real GN P increased at an
annual rate of 7.2 percent in the first quarter.
This rate is well above the 5.0 percent rise in
the fourth quarter of 1983, and is higher than
the 6.0 to 6.5 percent growth most forecasters were anticipating. Many people are
concerned that this strength means that the
economy may be growing too rapidlybecoming overheated, in other words-and
that this overheating will raise interest rates
and renew inflation.
The capacity utilization rate is a particularly
helpful measure in judging whether the
economy is overheating because it is
possible to identify a rate of capacity
utilization that, if maintained, is consistent
with no increase (or decrease) in inflation.
Factory operating rates above this
"threshold" utilization rate are associated
with increasing inflation, and below it, with
decreasing inflation.
Between January and February of this year,
capacity utilization in U.S. manufacturing
firms increased from 80 to 81 percent.
February's operating rate is no cause for
alarm, however. In the past, we haveexperienced that level without touching off an
upsurge in inflation. Our concern lies in
how much farther that rate can rise without
increasing inflationary pressures.
Stable-inflationcapacityutilization rate
<
Our research indicates that a capacity
utilization rate of 82 percent is consistent
with stable inflation, i.e., with no increase or
decrease in inflation. We estimated this
"threshold" rate for the periods from 1954
through 1973, then through 1977, and
finally through 1982. These were periods in
which the
economy experienced a
variety of economic shocks, such as the
Vietnam War, wage and price controls, and
u.s.
OPEC price increases, as well as progressively higher and more variable inflation.
Therefore, these periods are good alternatives with wh ich to test whetherthe
"threshold" utilization rate had changed
through time. We found that it has remained
constant at 82 percent through the changing
economic conditions since 1954.
The accompanying chart illustrates the
association between year-over-year
changes in the inflation rate and the level of
capacity utilization. The tendency we
observe is for inflation to decline when
capacity utilization averages below 82
percent, as in 1982 and 1983, and to
increase when the operating rate is above
that value. Around 82 percent, and within
the shaded interval, we observe relatively
small changes in the inflation rate, but no
general tendency for inflation to rise or fall.
The exceptions to this general tendency, as
in 1972 and 1975, can be traced to outside
shocks such as wage and price controls in
the former period and OPEC price changes
in the latter.
The shaded area indicates that there is a
zone or range of capacity-utilization rates,
centered around 82 percent, within which
there is no observable tendency for inflation
to increase or decrease. This range reflects
the fact thatthe 82 percent threshold rate is a
statistical estimate. The true rate may differ
from this estimate because of sampling error.
But it is possible to calculate a range of
utilization rates within which there is a high
probability the true rate will lie. As the chart
indicates, there is a high probability the
threshold rate is somewhere between 80
and 83.5 percent. This zone of uncertainty
about the true threshold rate is relatively
narrow, compared to the wide range of
observed utilization rates in the post-war
period which have varied on an annual basis
from as low as 69.0 percent to as high as 91.1
percent. Thus, it is possible to pinpoint the
Opi ni 0 nc;
i rl th I" (I <:'\;V,;1<'1i VI" du ! ,0 l
rWcesc,driiy (("fleei (ht> view" of tiw r1 1 illlagernent
of
. ldpral
Bank of
Francisco.
fH n! the Board Of CO\! E:'rnors of tfw· Fcderal
Rest' I've
f' I'll,
potential threshold rate with a relatively
high degree of accuracy,
greater tha'n what we have assumed. As a
rough rule of thumb, one percentage point
more real growth in either 1 984 or 1985
would increase capacity utilization about 1
percentage point, raising the probabil ity the
economy would be pushed into the risinginflation zone.
Other inflation influences
Thecapacity util ization rate is used to gauge
the extent of upward cost pressures caused
by an expanding economy. However, outside "shocks" also can affect the inflation
rate, at least temporari Iy. For the past ten
years, the U.S. economy has been jolted first
by energy price increases and then, more
recently, by unexpected reductions in OPEC
prices, Because of worldwide energy conservation, due in part to modest economic
growth that has checked demand, OPEC
may not change its prices very much in the
next year or so. Food prices may increase
this year as a result of the 1983 drought and
severe winter weather, but the amount they
will contribute to inflation in 1984 issmallabout 0.4 percent. Barring any other outside
shocks, the major changes in inflation this
year and next will be related to business cost
pressures as economic expansion
continues, and these pressures may be
measured by the spread between capacity
uti! ization and its "threshold" rate.
Accordi ng to this analysis, overheating that
risks renewed inflation is not likely to occur
in 1 984 if the economysl6ws from the strong
first quarter pace. Once readied, to maintain an average 82 percent operating rate
and hence to avoid increasing inflation, the
economy should grow at roughly its longerrun or potential rate, which most analysts
contend is about three percent for the next
several years.
Pricingdecisions
The positive correlation between inflation
and capacity uti I ization that we have
observed empirically is also one suggested
by economic concepts regarding market
pricing behavior. According to these
concepts, firms set prices as a mark-up over
their production costs. The size of the
mark-up depends upon demand pressures
on the existing capacity of the firm. As these·
pressures bui Id and uti! ization rates
increase, firms raise their mark-up on costs..
An increase in the mark-up during periods of
increasing demand may also reflect noncompetitive pricing behavior by firms that
feel they can raise prices without a serious
loss in sales.
Overheating?
The question of whether the economy is
overheating may be addressed by asking
what operating rates would prevail if the
economy grows about 5.0 percent over the
four quarters of this year and about 3.5
percent next year, as most analysts forecast.
This pattern, of course, suggests that real
G N P growth slows down this year from its
rapid pace in the first quarter. These yearly
growth rates are likely to lead to an average
capacity utilization rate 6f about 82 percent
in 1984 and 83.5 percent in 1 985, according
to our calculations. Compared with the
critical value of 82 percent, these rates are
consistent with no rise in inflation th is year
(excepting what food price increases may
contribute) and a possible increase next
year-possible, because 83.5 percent is on
the margin of the threshold range. The
inflation risk, of course, increases for both
this year and next if real GN P growth is
The major costs for most firms are wages.
Wages depend on expectations of future
prices by labor and business, the productivity of labor and demand pressures in labor
markets. Economists typically use the deviation of the unemployment rate from its
long-run equilibrium value (often called the
full-employment or natural rate of unemployment) to measure the amount of
pressure in labor markets. Unemployment
rates below the natural rate mean tight
labor markets and upward pressures on
wage costs. Unemployment rates above
2
the natu ral rate mean slower growth
in wage costs.
rate. Some economists have argued this
uncertainty has led to some in flationary bias
in past policy decisions. There was a natural
tendency, they argued, to err on the side of
underestimating the u n employmen t rate
consistent with stable in flation and therefore
to advocate policies which in retrospect
were too stimulative and inflationary. I f this
assessmentwere correct, the.use of capacity
utilization rates to gauge in flationary
pressures may be h elpfu l as an independent·
check on the in flation assessments made by
looking at u n employmen t measures.
Thus both reductions in unem ploym ent
(reflecting tightness in labor markets) and
increases in capacity u tilization (reflecting
growin g final produ ct demand) are
indicators of rising inflation . In practice,
capacity utilization and unemployment
generally give the same signal because
higher utilization rates are associated with
lower u nemploymen t so th at eith er measure
alone may be an adequate indicator. The
negative relationship between unemployment and inflation, popu larly known as the
Phillips Curve, has received wi de atten tion.
The capacity u tilization rate, however, may
be a more reliable i ndicatorof in flation than
the un employment rate. As the discussion
earlier indicated, the estimated threshold
capacity utilization rate appears to have
remained unchanged over time, givin g on e
some confidence th&t it remains a reliable
standard against which to assessthe curren t
inflation ary situation.
Conclusion
Some analysts have shunned the use of the
capacity u tilization data because they
contend that it is not a utili zation rate in
some absolute, or engineering sense, bu t·
depends to a degree on the ju dgmen t of the
business persons provi ding the data. This
may be true but, like inflation expectations
wh ich are difficul t to measure, capacity
utilization is an econ omi c concept bearing
on pricin g decisions. I t may be a vi rtu eofth e
capacity u tilization data series that i t
contains a ju dgmen t by the business firm of
its excess demands. And, importantly, the
series has had a stable and close relation ship
with changes in the in flation rate over time.
I t therefore merits serious consideration as
an inflationary signal.
In contrast, there is a good deal of
uncertainty surrounding the estimate of the
stable-inflation u n employmen t rate.
Economists agree that rate has probably
been increasing over the past 40 years, but
they have disagreed over the extent of
increase largely because there is n o
consensus on the determinants of the natural
RoseMcElhattan
Inflation and Capacity Utilization
Clu1ll9111n
Inllallon Rato
3
2
0
,
".
"' "
.
·2
·3
."
...
."
·4
76'
.5
Capadly utilization
70 72 74 76 78 80 82 84 86 88 90 92 (Manufaoturlng)
Failing
InHallon
Steady
Inllallon
Zone
Rising
InUallon
In'llI"" ,.le 10m•• ,u,od by
ClNI'
1I.1l0tOt.
Cap.oity umfullon In U.$.",a""lulUrlng!. pubJI'hf<lby IhIt F<>d.,al
R•••
",.ao.<d.r
G...
3
SS V1 0 I S HI: f
u018UI4Sl?M.4l?ln • u08aJO • l?pl?i\aN• 04l?PI
!Il?Ml?H'.
l?!UJOJ!ll?::>
• l?UOZ!JV'• l?>jSl?IV
(())
'J!I!!:) 'o::>sPU!!J:I
U!!S
Z!I':: 'ON l1WH:Jd
G1Vd : J9VlS0d 's'n
llVW
I SH 1:1
aU HOS: JHd
ssvn
{\
\ill!l{\Jr\2?@
BAN KING DATA-TWE LF TH FEDERALRESERVE
DISTRICT
(Dollar amounts in millions)
Amount
Outstanding
3/28/84
SelectedAssetsand Liabilities
large Commercial Banl(s
loans, leases and Investments 1 2
loans and leases 1 6
Commercial and Industrial
Real estate
loans to Individuals
leases
U.S. Treasury and Agency Securities 2
Other Securities 2
Total Deposits
Demand Deposits
Demand Deposits Adjusted 3
Other Transaction Balances4 ,
Total Non-Transaction Balances6
Money Market Deposit
Accounts -Total
Time Deposits in Amounts of
$100,000 or more
Other liabilities for Borrowed MoneyS
Weekly Averages
of Daily Figures
ReservePosition, All Reporting Banks
Excess Reserves ( + )/Deficiency ( - )
Borrowings
Net free reserves ( + )/Net borrowed( - )
Change
from
3/21/84
176,650
156,667
46,961
59,419
27,436
4,999
12,199
7,784
185,185
42,973
29,276
12,057
130,156
-
40,411
-
38,033
18,635
Period ended
3/26/84
188
44
144
-
-
Change from 12/28/83
Percent
Dollar
Annualized
390
243
273
17
118
3
69
79
322
256
265
133
200
-
-
625
1,312
998
520
785
64
308
379
5,812
6,264
2,055
718
1,171
100
-
-
,
814
-
61
506
132
4,372
1.4
3.3
8.6
3.5
11.7
5.0
9.8
18.5
12.1
50.8
26.2
22.4
3.6
8.2
-
1.3
-
76.0
Period ended
3/12184
o
49
139
1 Includes 1055 reserves, unearned income, excludes interbank loans
2 Excludes trading account securities
3 Excludes U.S. government and depository institution deposits and cash items
4 ATS, N OW, Super N OW and savings accounts with telephone transfers
S Includes borrowing via FRB, n &l notes, Fed Funds, RPsand other sources
6 Includes items not shown separately
Editorial commentsmay beaddressedto the editor (Gregory Tong)or to the author. , .. Freecopiesof
Federal Reservepublications can be obtained from the Public Information Section, FederalReserve
Bank of San Francisco, P.O. Box 7702, San Francisco94120. Phone(415)974-2246.
-,
@FedFRASER