Industrial capacity and inflation

Statistics Canada reports on industrial capacity, an important data point for the Bank of Canada, ever watchful for inflation:

Industrial capacity utilization rates
First quarter of 2006

Capacity use among Canadian industries edged down in the first three months of 2006 in the wake of the rising loonie and a decline in foreign demand for some manufactured goods.

Industries operated at 85.9% of their capacity between January and March, compared with 86.1% in the fourth quarter of 2005.

Still, rates have remained relatively stable over the past two years, and are holding at near-record levels of capacity use. The first-quarter dip put the rate 1.7 percentage points below the peak of 87.6% reached in the first quarter of 1988.

The industrial capacity utilization rate is the ratio of an industry's actual output to its estimated potential output. With this release rates have been revised back to the first quarter of 2004 to reflect the revised source data.

Despite this high capacity utilization, inflation has remained modest. The Consumer Price Index (excluding the eight volatile components identified by the Bank of Canada) rose 1.6% between April 2005 and April 2006.

Alas, despite high capacity utilization, CPI inflation remains low. It seems to me there is a disconnect on this front, especially since we export so much of our industrial output. Why should we care if capacity is reaching its limits if foreigners are bearing higher prices? And if anything, tight capacity is a signal to build more capacity through new capital investment, of which there has been too little in recent years when benchmarked against GDP.

This view is too rooted in an "old economy", manufacturing-centred view of the world. Is there really a capacity constraint on a company selling software or even a company producing pharmaceutical drugs? In these cases so much of the cost of production is upfront cost while the marginal cost is very very low, if not zero in the case of software.

The other part of the equation is that we import a lot of consumer goods, so prices, if they are going up at all, are out of our control. Supply-push inflation, as in the case of high oil prices, should not lead to a knee-jerk response by the Bank of Canada to raise interest rates, a blunt instrument to slow down the economy.

All of which reinforces my initial point that the Bank of Canada is too obsessed with inflation.

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