The Near-Term Economic Outlook
A famous economist characterized recent years as the “age of turbulence,” and although he was not specifically referring to the last few weeks when he titled his memoirs, the label still fits. With continuing weakness in the housing market, turmoil in financial markets from subprime mortgage difficulties, and the recent weakness in output and employment, economic observers are struggling to ascertain where the economy is headed. Should policymakers be worried about the economy slowing too much or about inflation getting out of hand?
The Federal Reserve Board’s monthly indices of industrial production and capacity utilization, which measure the quantity of output produced by the nation’s factories, mines, and utilities and the ratio of what they produced relative to what they could have produced given their existing capital, are some of the high-frequency series that help give economic observers a timely indication of the economy’s direction. According to these indices, the economy does appear to have down-shifted.
In August, total industrial production growth slowed to 0.2 percent, down from July’s rate of 0.5 percent. Although the deceleration was broad-based, the growth rate remains only modestly below its average over the last year. Energy-related industries, which comprise over 20 percent of the total industrial production index, expanded 2.3 percent last month, reversing declines averaging 0.2 percent in May, June, and July. High-technology industries (up 0.8 percent last month and 19.5 percent year-over-year) continue to fare better than non-high-technology ones (down 0.3 percent last month, but up 0.6 percent over the past year). Even so, non-high-technology industries still comprise the bulk of the total index, 75 percent compared to 5 percent for high-technology.
Other things being equal, when output growth slows, there is less reason to worry about inflationary pressure. However, whether this holds in the present case depends on how much pressure is already present. A more direct measure of potential supply-side price pressures comes from capacity utilization, which measures how much the economy is producing relative to the amount it could produce if capital were fully employed. The index stood at 82.2 percent in August, lower than the historic high of 85.1 percent achieved in 1994–1995, but higher than the 1972–2006 average of 81.0 percent, and thus it remains in a range that warrants watchful attention. Capacity utilization indices for energy-related industries and non-high-technology industries have both tracked fairly closely to the overall index. The index for selected high-technology industries has shown a bit more slack than the rest of the index. At 78.6 percent, the capacity utilization of these industries is well below their peak of 92.5 percent in May 2000 and modestly below the 80.1 value reached in October 2006.
Whether this modest tightness in productive capacity becomes more of a problem depends in part on how much investment expands the economy’s capacity. Currently, investment as a share of GDP remains below the peak it reached in 2000, and consequently, capacity is not growing as quickly as it had been. This reduction in investment matters, not just for the price pressures it could cause, but also because investment is often the way new production technologies and products are introduced. Their introduction boosts labor productivity and, in the long run, per capita personal incomes and living standards. Consequently, a more important concern in the long run is not whether the economy has slowed or whether price pressures have increased, but whether the recent slowdown in productivity growth is temporary or more long lasting.