Always Check The Economic Calendar
The Federal Reserve’s monthly index of industrial production (and the related capacity indexes and capacity utilization rates) covers manufacturing and mining; along with electric & gas utilities.
The industrial sector, along with construction, accounts for most of the variation in GDP over the course of a business cycle. The production index measures real output and is expressed as a percentage of real output in the base year, 2012.
The capacity index, which is an estimate of sustainable potential output, is also expressed as a percentage of the actual output of 2012 (base year). The rate of capacity utilization equals the seasonally adjusted output index expressed as a percentage of the related capacity index.
The index of industrial production is available by market and industry groupings. The major groupings are:
- final products (consumer goods, business equipment and construction supplies)
- intermediate products and materials.
Why is U.S. Industrial Production important?
Investors want to keep their finger on the pulse of the economy because it forms expectations on how various types of investments will perform.
- The stock market likes to see healthy economic growth because that translates to higher corporate profits.
- The bond market prefers more subdued growth that won’t lead to inflationary pressures.
Tracking economic data like U.S. industrial production gives investors and traders an idea of what to expect in each market.
The Fed’s Index of industrial Production
The index of industrial production gives us an idea of how much factories, mines and utilities are producing. The U.S. is a consumer-based economy. The manufacturing sector accounts for less than 20 percent of the economy, however most of it is cyclical variation. Consequently, this report has a big influence on market behavior.
Why does such a small ratio of the economy wield so much influence in the eyes of investors? Remember, variation = volatility. Volatile markets will either make or break an account.
Every month, we can see whether capital goods, or consumer goods, are growing more rapidly. Are manufacturers still producing construction supplies and materials? This detailed report shows which sectors of the economy are changing.
Now, the capacity utilization rate is a bit different. It provides an estimate of how much factory capacity is in use. If the utilization rate gets too high (80-85% range), it can lead to inflationary bottlenecks in production.
The Federal Reserve watches this report closely and supposedly …arguably …sets interest rate policy on the basis of whether production constraints are threatening to cause inflationary pressures -when you hear about changes in inflation, think fixed income, think bond market.
Remember, in finance “fixed income” does not mean your grandparent’s monthly government subsidy.
The bond market can be highly sensitive to changes in the capacity utilization rate. However, in this global environment, global capacity constraints may be more significant to fixed income than domestic capacity constraints.
The Meaning of It All
Industrial production and capacity utilization indicate trends in the manufacturing sector, but also whether resource utilization is strained enough to forewarn of inflation.
Also, industrial production is an important measure of current output and helps investors identify turning points in the business cycle –recession expected, get ready to buy equities …recovery expected, be prepared to sell.
The bond market will rally with slower production and a lower utilization rate as capital flows out of equity and into bonds. Bond demand will fall when production is high and the capacity utilization rate suggests supply bottlenecks.
The production of services has gained prominence in the United States, but the production of manufactured goods remains key to the economic business cycle. A nation’s economic strength is judged by its ability to produce domestically.
Many services are necessities of daily life and would be purchased regardless of the business cycle. However, consumer durable goods and capital equipment are purchased when the economy is expected to strengthen.
When expected demand for manufactured goods decreases, it leads to less production along with declines in employment and income.
The three most significant U.S. sectors are motor vehicles/parts (auto loan bubble?), aerospace and information technology. Volatility in any one of these sectors can affect the U.S. economy.
Industrial production is subject to some monthly variation. The three-month EMA or year over year percent changes provide a clearer picture of the trend.
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