Low Unemployment with falling Capacity Utilization… Not a good sign for Fed Liftoff
Should the Fed raise the base interest rate? They really shouldn’t at this point. Will they? They probably will because they still see years of growth. I do not see years of growth ahead… Let me explain.
Almost one year ago I wrote that capacity utilization would start falling. (link) It has fallen since that time, even until today’s report that capacity utilization in August was 77.6%. This number was below expectations but perfectly in line with a limit line in a model that I use.
The model plots the movement of capacity utilization and unemployment. The model has two limit lines that act upon the increasing utilization of labor and capital. One for Effective Demand (basically labor share) and one for Profit Maximization (equation in graphs). The utilization of labor and capital moves toward the limits during a business cycle to increase profits. Once the movement hits the limits, profits are further increased by only moving downward along the limits, which means that capacity utilization will decrease as unemployment falls. This pattern has existed for decades before a recession. When the plot starts to pull away from the limits, a recession is beginning.
Here is the model from a year ago.
When I saw the plot reaching the limit lines last year, I wrote…
“My sense is that firms are in a race to maintain profit shares at the end of a business cycle. They felt the chill of declining profits in September. From here on out, firms will have to contract in order to maintain profit shares, as seen by the plot hitting the orange line. Now firms will have to contract capital utilization while trying to maintain the same output in order to maintain profit rates.”
So here is the model with data since September of 2014. The coefficients seen at the top are the same in both graphs for easier comparison. The coefficients though can change if labor share was to significantly change.
Yes, everyone loves the fact that unemployment is falling, but at the same time capacity utilization is falling perfectly to keep profits maximizing. Is that a good thing? Well, the business cycle stays alive and more people get hired. However, this process has its limits. Capacity utilization is now being maxed out on profits. Generally throughout the economy, it is currently only profitable to lower unemployment at some cost of capacity utilization. When capacity gets restricted too much without labor share rising, a recession becomes easier to trigger. Then we would see the plot moving up and to the left with capacity utilization falling and unemployment rising.
So the Fed decides this week whether they should raise the Fed rate or not. They are encouraged by the low unemployment number. Yet, from my perspective, the economy is very close to the end of the business cycle and too sensitive to tightening of monetary policy. The Fed could push the economy into a recession with a Fed rate rise. Basically, the Fed can no longer raise the Fed rate during this business cycle. It is too late.
According to the graphs, the natural rate of unemployment would be where the plot touches the limit lines. In this business cycle, it appears to be around 5.6%. So we have already passed the natural rate of unemployment. It is doubtful that we will see much if any inflation as conditions just do not support inflation with low interest rates promoting supply vis-a-vis weak labor share of income.
So the Fed is seeing that unemployment will drop further, and they expect some rise in inflation. However, if they are expecting a few more years of growth in this business cycle… I beg to differ.
In order to extend the life of this business cycle, the Fed should really not liftoff the interest rate.
Update:
J.Goodwin in the comments below requested a look at this model for the 1980’s. Here it is. You will see that the effective demand limit was higher at 80.2%. The “b” coefficient is the same as now. The movement of capacity utilization and unemployment headed straight for the crossing point of the two limits as they did in this business cycle. You will also see that in mid 1989, capacity utilization started to fall abruptly leading up to the recession a bit later.
You will also notice in the middle of the plot that in 1986, capacity utilization fell abruptly while unemployment stayed fairly steady. 1986 and 1987 were a global crisis of foreign debt which stressed business. But in the end the economy pushed through the problems because there was still effective demand to expand the utilization of capital and labor together.
So, another Fed inspired recession. What else is new?
Yeah, but it fell in the mid-90’s and mid-80’s as well. This looks totally oil investment driven. In otherwards, a recession a part of the economy that makes up barely 1% of it. The profits thus are not being driven by the sector. Once the oil based investment overhang ends, up capacity will go. If anything, 78+ is above average in modern times.
Not a good indicator. Of course the pattern, follows a recession. But those are due to financial issues.
Try harder and understand what caused past recessions.
Another issue is whether domestic oil production has overcut production which leads into the above. They had cut production down to 45 Brent. I suspect they see another 10-15 nominal decline based on July/August cuts. If the prices doesn’t fall much below 40, then the business will level off.
Rage,
What I see is a pattern that has been consistent over the decades. The pattern is happening again. The foundation of the pattern is Effective Demand, which in my mind will limit the overall economy at some point.
When capacity utilization fell in the 90s, the economy was against the effective demand limit. And also look at how capacity utilization held constant for 3 years before the 2008 recession. Again the economy was against the effective demand limit for those years too.
People do not see this happening because they still expect capacity utilization to return to levels seen in previous business cycles. However, look at what’s happened to labor share. It was always considered to be stable. Now it has fallen to unusual levels, and shows no sign of returning to previous levels.
https://research.stlouisfed.org/fred2/graph/?g=1BNs
Edward can you post (repost maybe) 1986?
This is the last time there was an oil glut. Of course not everything else is apples to apples.
Edward,
You wrote: “Then we would see the plot moving up and to the left with capacity utilization falling and unemployment rising.”
So your plot is showing us some of the late effects of the 2008 recession.
In the first 6 months of 2009 unemployment was still going up and capacity utilization was still going down. (Up and left)
Then in the next 4 months of 2009 unemployment was still going up but capacity utilization was going UP. (Up and right)
After that, unemployment was bumping along within a narrow range and capacity utilization is continuing to go up until November 2010.
In November 2010 unemployment starts to really go down and capacity utilization continues to go up. (Down and right)
Have I got that much right? Not missing any data points?
I think the Fed has no real choice about raising interest rates. Their zero interest rate policy has encouraged rampant speculation in commodities and stocks. This has allowed the tail to wag the dog. (Finance dominating the main street economy.)
The current economic conditions are very different from those leading up to the 2001 recession.
–
J.Goodwin wrote: “Of course not everything else is apples to apples.”
Especially the level of Total Household Debt. The buildup of that debt, from about 1996 to 2008, makes our current situation unlike any other time in history except the Great Depression. Modern consumers no longer have the ability to rapidly increase their debt load. Now they must live on their stagnant wages.
During the 1920s consumers bought the newly invented or improved consumer goods, with the newly instituted installment loans. Sales were already slowing before the crash of October 1929.
See: “Credit Expansion, 1920 to 1929, and its lessons” by Charles E Persons – Quarterly Journal of Economics November 1930
J.Goodwin,
I will post an update for the mid 80s. There was not officially a recession, but there was really something similar.
JimH,
Yes, you got the movements right. There is a clock-wise movement throughout the business cycle. Yet after the 2008 recession, it took unemployment a longer time to start coming down. So the clock-wise circle was more pronounced.
J.Goodwin,
update posted for the 1980’s.
sorry Ed, you making intellectual points. Not real world points. Of course, recessions start in this manner, but you also, have false alarms, especially in this post-industrial economy that started in 1980.
lets note my company got a new boost in oil related products after the US inventory drawdown today. they no longer see prices going down to 30 dollers a barrel.
Also to clear up, the drop in August utilization was heavily impacted by refineries. That will reverse in September.
Rage and Bert,
Remember now… the limits can shift right if labor starts to rise to a new level. This rise has not happened yet though. If it does, you can see an increase in capacity utilization.
Also, Manufacturing capacity dropped in August too. There is more than just refineries in this situation. Also capacity held low at all stages of process, crude, primary and finished.
Another factor to keep in mind is that emerging markets are also tied into the effective demand limit of the US. Their slowing growth will weigh down on our growth going forward. Basically, at the effective demand limit, profits become competitive. When one firm gains in profits, another loses. This does not happen as the economy recovers. Companies can grow profits together.
The dynamics are coming clear.
Here is a video I watched today from Kyle Bass… He is insightful. There are some heavy months ahead for the global economy.
http://www.cnbc.com/2015/09/15/hayman-capitals-bass-chinas-real-problem-is-its-banking-sector.html
I frankly don’t see that at all. America’s growth comes from different sources. If anything, their slowing growth will speed up our growth.
Bert,
It should also help to raise labor share back up to previous levels and heal the illness in the US economy. Noah Smith made this statement a while back too. I am ready for China to have problems.
Edward,
Kyle Bass diagnosed the US investment banker’s problems in July 2007, if my memory is correct. But that did not require a diagnosis of the larger underlying problems in the US economy. He is probably correct about China’s banks but that is not our primary problem.
One way of looking at this is that we could be nearing the end of the free trade game. Export based economies raise production to export to the developed world, production is reduced in the developed world, eventually consumers/workers in the developed world end up with stagnant wages and high debt, and those consumers tighten discretionary spending. (Stating the obvious, consumers need incomes!) Then the export based economies import even less from the developed world, and the consumers in the developed world slow discretionary spending even further. Repeat and repeat again, each time the export based economy slows further.
We are not buying housing, food, or energy from China. We are buying discretionary goods from them.
In the end, labor share in the US economy is the controlling factor.
Effective demand was always a requirement but it could be ignored as long as the consumers in the economy were also that economy’s producers. That connection was split when production was moved overseas. After that split, ignoring effective demand was a very large mistake.
Consumers can not spend what they do not have. What US consumers have now is stagnant wages and high Total Household Debt.
JimH,
Yep… Other countries like China are realizing the reduced effective demand in the US.
Economists do not have a way to formulate effective demand yet. They still see that demand will grow by making it easier for companies to stay in business. Over-supply capacities do not raise effective demand.
Your words hit the target…
“What US consumers have now is stagnant wages and high Total Household Debt”. Right, but the high household debt goes back to declines in real wages since the 70’s due to replacing production with consumption as the cold war was winding down.
The next debt bubble will produce a boom as always. Except now in the advanced economy sense, it goes into consumption rather than investment. Labor Share is overrated right now. Look at debt instead.
If we cannot get China to the TPP table and they continue to over produce and manipulate their currency then we will continue to loose. As the supply far out reaches the effective demand more and more companies in America and else where will be driven out of business by this unfair competition. Raising the interest rate will not help nor will raising the minimum wage matter much because as you said we have become a debt driven economy as our ability to consume is slacking more and more…Here is our economic house currently. There is an 800 lb. gorilla sitting in our economic living room and somehow we must choose to address it. Over in the family room there is a capitalist Frankenstien called multinational globalism that has no patriotism, no flag, morality and has become a cancer of greed model. Some like to call it business. This greed model will devour anything in its path to make a profit.The “scorched earth” policy is very descriptive od their corporate “ethos”…The second civil war is coming. We are just waiting for our next critical mass Rosa Parks event to happen…The house is not currently standing on strong economic foundation- principles…IMHO.