Total Industrial Production was unchanged in April relative to March, which was well below the expected 0.5% increase. That is a very disappointing performance. The revisions were also downbeat, with the March number being revised to up 0.7% from 0.8% and February revised down from -0.1% to -0.3%. Relative to a year ago, total Industrial Production is up 5.0%. In normal times, that would be great growth, but for coming out of a deep recession, it is just OK.
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.
Thus it is important to look at just how the manufacturing sector is doing alone. It fell 0.4% in April. That is down sharply from an increase of 0.6% in March, and the March number was revised down from a 0.7% increase. In February, factory output was up just 0.2%, not the 0.6% increase reported last month.
Year over year, factory output was up 4.6%. Most of the decline in factory output came from the Auto industry, as part shortages due to the Japanese disaster slowed production here. Excluding the auto sector, manufacturing output was actually up 0.2%. Still, that is not a very robust increase, even without the tsunami impact. The disaster, though, is responsible for the first decline in factory output after nine straight months of increases.
Utility Output
Utility output rose by 1.7%, an acceleration from the 0.7% increase in March, and much better than the 2.3% decline in February. The jump in utility output makes the overall headline number look much better, but was probably mostly a function of the weather, not a surge in economic activity. Year over year, utility output was up 8.0%. The manufacturing-only number is a better gauge of overall economic activity.
Mining Output
The third sector tracked by the report is Mining (including oil and natural gas). The output of the nation’s mines rose by 0.8% in April. While that is a sharp deceleration from the 1.4% gain posted in March, it is still a very healthy increase. The March number was a rebound from a weak February, when mine output dropped 0.9%. Year over year, mine output is up 4.1%.
Results by Stage of Production
By stage of production, output of finished goods fell by 0.5%, reversing a 0.5% increase in March (revised down from a 0.8% gain). Considering that February output of final goods was down 0.1%, that makes it two out of the last three months that production of final goods has fallen, which is not a good sign. Relative to a year ago, finished goods production is up 5.2%.
Finished goods are separated into consumer goods and business equipment, and there is a real dichotomy between the two, particularly year over year. 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 fell by 0.5%, that partially reverses a 0.9% increase in March. In February, final consumer goods output plunged 3.5%. Year over year, output of consumer goods is up 3.9%.
Business Equipment Output
Business equipment output, on the other hand, has been consistently strong but has cooled off lately, falling by 0.4% on top of a 0.5% decline in March, but after a 0.9% rise in February. March was revised sharply lower from a rise of 0.4% reported last month.
February was also revised down, but only by 0.1% from 1.0%. Business equipment production is up 9.9% from a year ago. Business investment in Equipment and Software has been one of the strongest parts of the economy, contributing 0.80 points of the 1.80% total growth in the economy in the first quarter, even though it makes up just 7.38% of GDP.
That was a big improvement from the fourth quarter when it added 0.54 points of the 3.10 points of total growth. The sharp downward revisions to March and February suggest a downward revision to GDP growth for the first quarter. The lackluster April numbers tell us that we are not off to a good start for the second quarter.
Materials Output
Output of materials rose 0.3%, a big deceleration from an increase of 0.9% in March, but better than the 0.3% decline in February. Materials output is up 5.4% 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. Notice, however, that the slope of both lines in this recovery is much steeper than in previous recoveries.
Capacity Utilization
The other side of the report is Capacity Utilization. This is one of the most under-appreciated 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 help it this month, and it could use the help. Total Capacity Utilization fell to 76.9% from 77.0% in March. Also, March was revised lower by 0.4% as was February, from 76.9% to 76.5%.
The revival of capacity utilization has been going on for more than a year now. A year ago, just 73.2% of our overall capacity was being used, and that was up from a record low of 67.3% in June 2009.
Normal Levels & What They Mean
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 80.4%. 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 9.6% 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 1990’s doing so on two separate occasions).
Factory utilization fell to 74.4% in April, down from 74.8% in March (revised down sharply from 75.3%) and matching the February level of 74.4% (revised down from 74.9%). That is still up from 70.7% a year ago, and the cycle (and record) low of 64.4% in June 2009. We are still well below the long term average level of 79.0%, so as with total capacity, we still have a long way to go on the factory utilization level.
The major culprit for the decline in utilization came from the Auto industry, where due to shortages of Japanese parts, capacity utilization fell to just 61.9% from 68.0% in March. Still, that is a heck of an improvement of the Great Recession low of just 34.8%.
Total capacity fell by 0.1% over the last year, and manufacturing capacity was down 0.6% from a year ago. Decreased capacity is a tailwind for increased capacity utilization, but at the current level it is a breeze, not a gale. For most of the last two years we have seen year-over-year declines in capacity.
The Good & the Bad
While shrinking capacity makes it easier to use the remaining capacity at a higher level, it is not a good sign for the economy. It represents a permanent loss, rather than a temporary idling, of the country’s economic potential.
Mines were working at 88.2% of capacity in April, up from 87.6% in March and from 86.6% in February. A year ago, they were operating at 85.5% and the cycle low was 79.0%. We are actually now above the long-term average of 87.4% of capacity. When we are at or above the long-term average, minor fluctuations should not be a big macro concern.
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 1.1% 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 rose to 81.6% from 80.4% in March and the 80.0% level in February A year ago, utilities were operating at 78.3% of capacity. We are far below the long-term average utilization of 86.6%. We are actually not that far above the Great Recession low of 79.2%.
Increasing utility utilization faces a headwind because unlike manufacturing, our power plant capacity has actually been increasing significantly, up 3.6% year over year. With virtually no strain at all on the power grid right now, we could safely take the most vulnerable nuke plants off line to inspect them from top to bottom, a step that Germany took response to the Japanese disaster. Shutting them down a few months from now when the weather gets hotter and power demands increase would be much less attractive than ding it now when power demands are very low.
The weather actually helped the utility part of the total capacity utilization, and made the overall report look better than it actually was. In assessing the state of the overall economy, it is better to just look at the manufacturing numbers. In February, including the Utilities made things look soft; when the weather-related effects of the Utilities are removed, it was a fairly solid report. On the surface, this looks like a weak report, but considering the Utility effect, it was even worse than the headline suggested.
By Stage of Processing
Utilization of facilities producing crude goods (including the output of mines) rose to 87.0% from 86.6% in March and up from 85.9% in February. A year ago, crude good facilities were operating at 84.9% of capacity, and the cycle low was 77.6%. We are now above the long-term average of 86.4%. Considering that crude goods capacity is up by 0.9%, that is a very solid showing.
Utilization for primary, or semi-finished goods rose to 74.5% from 74.4% in March, and from 73.7% in February. While that is much better than the 70.2% level of a year ago, and the cycle low of 64.9%, it is a very long way from the long term average of 81.3%. Part of the year-over-year increase is simply due to shrinking capacity, which was down a steep 0.8%.
Utilization of facilities producing finished goods fell to 75.6% from 76.1% in March and 76.0% in February. It is up from 72.2% a year ago, and a cycle low of 66.8%. It remains below its long-term average of 77.3%. Interestingly, our capacity to produce finished goods has actually increased by 0.7% over the last year, so the rise in utilization there is facing a headwind. Part of that is due to Utilities, since electricity is considered a finished good.
Deeply Disappointing
This was a deeply disappointing report, with both production and utilization coming in well below expectations. Not only that, but the revisions to the previous months were down sharply. The disappointment came even with a tailwind from the utility sector, which means the actual situation is weaker than the headlines would suggest.
The decline in capacity makes increasing the utilization of the remaining capacity easier, but it is not what we really want to see. Still, the rebound off the bottom has been extremely strong, and the year-over-year numbers are very robust. Most of the slowdown came from the Auto industry, and there is not all that much that Ford (F) or General Motors (GM) could do about the tsunami, and both seem to be in better relative shape than their Japanese rivals.
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 from physical capital, much like the employment to population ratio 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.
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. Conversely, big cuts in spending now will slow the economy significantly, to the tune of hundreds of thousands fewer jobs being created in this year and 2012. That means fewer people without income, and hence fewer people paying income taxes. Cutting $39 billion from spending will not cut $39 billion from the deficit. The actual deficit reduction is likely to be less than half that amount.
Attack of the Anti-Stimulus
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 stimulus from QE2 will end in June. The stimulus from the tax deal will wear off at the end of 2011. Hopefully the economy will be self sustaining at that point (“hopefully” being the operative word).
We have hit the debt ceiling, and the Treasury is desperately trying to juggle accounts to keep the government from defaulting, but that can’t last beyond the start of August. If Congress has not raised the debt ceiling by then, things will really start to hit the fan. Not raising the debt ceiling would be likely to have even more devastating consequences to the economy than the collapse of Lehman Brothers had. The net result would end up being a huge jump in the deficit, just as happened after Lehman failed.
The most likely path is still that Congress will come to its senses, and stop playing chicken with the entire world economy and increase the limit. The problems with games of chicken is that sometimes people don’t bail out in time (or as happened in “Rebel without a Cause,” their clothing gets caught) and accidents happen.
The chance of such an accident happening is increasing, if still relatively low. It might make some sense to buy some insurance in the form of out of the money puts to protect yourself just in case there is a major miscalculation in Washington.
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