The Federal Reserve emerged from its cloak of secrecy last week and issued a pronouncement after a meeting of the Federal Open Market Committee. "There will be no further announcement," said the Fed, which means the central bank won't increase short-term interest rates for now. But despite this momentary pause in monetary pressure, most analysts believe that Federal Reserve Chairman Alan Greenspan will hike rates again before the end of the year.
One key indicator that may be spooking the bond market and possibly driving the Fed toward its sixth rate increase of the year is rising factory capacity utilization, which hit a five- year high in August. When plants run full tilt, according to conventional economic wisdom, demand for scarce resources increases and the hunt for workers intensifies. Under this scenario, costs for supplies and labor escalate, and inflation sets in.
Excess capacity. But many economists argue that it is wrong to rely on manufacturing capacity figures when deciding whether to raise interest rates. In the past decade, higher capacity utilization has not set off inflation. One reason for this is the surplus of global capacity in many industries. When a factory is running near its limit today, it can frequently offset shortages by purchasing supplies offshore or adding production at foreign plants. This has been the case in the semiconductor and computer sectors. Says economist David Wyss of DRI/McGraw-Hill: "There is plenty of excess capacity in Europe and Asia and, as a result, the natural bottlenecks are not developing as quickly in this expansion." Another factor is rapid technological change, which is stimulating heavy capital investment by American companies. A recent study by Goldman Sachs estimates that the 12 percent annual rate of real capital spending over the past two years is far greater than the 4 percent growth in capital spending needed to replace worn-out machines every year. This means that productive capacity will grow at an accelerated rate over the next two to three years, constraining price increases.
The low inflation rate is also explained by the fact that there is currently little pressure on companies to raise wages. Daniel Bachman, a senior economist at the WEFA Group, has found that the largest job growth in the labor market is occurring at the managerial and professional level. But, according to Bachman, the unemployment rate in this segment is still higher than it was at the end of the recession. And with so many professionals and managers still searching for jobs, the prospects for wage inflation are greatly diminished. "Without wage inflation," explains Bachman, "shortages in the economy don't create sustained upward movement in prices. What they create is occasional sharp upward price movements that are not transmitted through the economy by higher wages."
If the Fed places too much emphasis on factory utilization numbers as it deliberates the course of interest rates, it could easily misjudge the U.S. economy's potential to grow without inflation. The cost of that miscalculation -- higher rates -- would place a heavy burden on American companies and consumers.
Two tracks Higher capacity utilization in American factories does not trigger inflation at the wholesale level.
