Note to Fed: Don’t base the rate hike on capacity utilization
by Jared Bernstein and Josh Bivens
On January 31, the Federal Reserve Open Market Committee (FOMC) will meet to determine whether or not to raise the key interest rate under their control. As the economy has gained momentum over the past few years, the FOMC has raised the so-called federal funds rate at each of their last 13 meetings. Whether it will raise the rate again depends in large part on its assessment of the inflationary pressures building in the U.S. economy.
Several analysts, including a member of the FOMC, have pointed to the United States’ climbing capacity utilization rate as an argument for another interest rate hike. The capacity utilization rate is a measure of how much of the nation’s productive capacity is actually in current use producing output. As such, it has traditionally been viewed as a measure of how much slack exists in the economy. As the capacity utilization rate rises, it is feared that bottlenecks or shortages could lead to inflationary pressures that would drive prices higher. Several analysts have pointed to a rate between 81% and 82% as a tipping point over which inflation is spurred. In December, this rate rose to 80.7%, stoking inflation fears and leading Federal Reserve Board Governor Susan Schmidt Bies to comment that “tight resource utilization is likely to put pressure on prices.”1
These fears, however, are misplaced: the relationship between the level of capacity utilization and price pressures has broken down over the past two decades. This shouldn’t be too surprising, as the capacity utilization rate measures only activity in the mining, manufacturing, and utilities sector. These sectors account for a shrinking share of total economic output, so we might expect capacity utilization rates to provide less information over time about the true state of economic slack. Also, increased international trade has reduced the effect of domestic supply constraints on prices.
Figure A shows the results from a conventional statistical analysis that estimates the extent to which information about capacity utilization provides any information on inflationary pressures (the bars plot the coefficients from a regression model that controls for energy prices, but the results are the same when we use core inflation, i.e., excluding energy).2 The first bar, derived from an analysis of these relations over the 1967-83 period, shows an economically and statistically significant coefficient, implying that a one percentage-point increase in the capacity utilization rate would lead inflation to grow about 0.09% faster over a quarter and about 0.4% faster per year.
But when we run the same model beginning in 1983 to the present, the coefficient falls to about zero and is statistically insignificant, meaning capacity utilization provides no power to predict inflation over these years.
Old rules of thumb die hard in economics, but changes in the economy appear to have broken the inflationary link between the level of capacity utilization and inflationary pressures.
1. See “Inflation hit five-year high of 3.4% last year: Wages didn’t keep up, Labor Department says” from the Washington Post, January 19, 2006, page D1.
2. We mimic the analysis in Emery and Chang, “Is there a stable relationship between capacity utilization and inflation,” Federal Reserve Bank of Dallas, Economic Review, 1997q1; http://www.dallasfed.org/research/er/1997/er9701b.pdf