Why Is Inflation Falling?
In a pair of previous posts about the CPI and PPI, I pointed out that inflation is still falling in the US, with no sign yet of stabilization. I didn’t really address the reasons why inflation is falling so persistently, however. The most important reason, I think, was given in another data release last week: the Fed’s estimate of Industrial Production and Capacity Utilization. While the headlines generally focus on IP, it’s actually CU that’s more interesting to me. Because our CU is low – very low – and that’s exactly what is pushing the US economy dangerously close to deflation.
Over the weekend, the NYTimes provided a story about this phenomenon with some illustrative anecdotes. But as the old economists’ adage goes, the plural of anecdotes is data, and that’s what can really make a story convincing. So here’s a graph showing CU from 1985 to today:
The pink line, scaled on the right axis, shows the total capacity in the US, and reveals that firms added an astonishing amount of productive capacity during the late 1990s. They’ve continued adding to capacity since then, leaving the US able to produce 50% more than we did just 6 years ago. In other words, the US economy can produce much more stuff than there is demand for.
This is reflected in the blue line, which shows capacity utilization – the percent of the US’s industrial capacity that is working – and is measured along the left axis. The striking thing about it is that it has been unprecedentedly low for the past 2 years – and hasn’t started improving yet. With all of that excess capacity, firms have no choice but to offer sales and otherwise keep their prices low, in order to try to boost their businesses and get a reasonable return out of their existing assets. Based on how high the total capacity index is, it looks like it will take years more of low growth in capacity before the productive overhang disappears.
That’s why my bet is that we will continue to see disinflation for some time to come. Prices won’t start rising until our capacity utilization index starts really increasing. And as far as that goes, the US economy has yet to show the first signs of improvement.