Closing the Gap

By ,   November 21, 2014

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Investors constantly monitor the state of the economy to gauge the health of business in the United States.  One measure of economic “efficiency” can be viewed by looking at Capacity Utilization rates.  These rates basically illustrate how much a company can produce before it needs to invest in new equipment to expand.  Therefore, if utilization rates are low, companies have plenty of machines available to meet demand.  As rates go higher, companies have to build new factories or buy new equipment to meet growing demand.

 As we have mentioned, the Federal Reserve is closely watching wage data for signs of inflation.  In the chart below, we see a positive relationship between capacity utilization and wages over time.  However, in the current recovery, we have not seen wages increase as utilization has bounced back.  We do not think this discrepancy can last for several reasons.  

First, capacity utilization can only increase so much before firms are forced to add facilities, equipment, and new workers to meet demand.  With rates now above longer term averages, we feel pressure will mount and companies will begin the expansion process.  Secondly, with the decline in oil prices and the appreciation of the U.S. dollar, U.S. consumers have more disposable income for spending.  Lastly, the unemployment rate has fallen below 6% bringing our workforce closer to “full employment”.  As the unemployed pool of workers fall, wages are likely to increase as companies compete with one another for skilled talent.

Another observation in the chart below is the rate of change in wage increases.  History shows that once increases begin, they can spike rather significantly in a short amount of time.  Such rapid changes could explain why the Fed is watching wage inflation so closely.  

 Capacity Utilization Rate and Wages