April 21, 2006, 8:40 a.m.
Seeing Through the Interest-Rate Static
Some Fed forecasters suffer from an inert worldview.

By John Tamny

With government measures of economic activity in the U.S. continuing to register positively, the Wall Street Journal’s Greg Ip recently made forecasts about how the Federal Reserve might respond in the coming months. Though Ip hinted at the possibility that the Fed would soon end its cycle of interest-rate hikes, he cited “upbeat economic news, such as March’s hefty job gains” and an “economy near full capacity” as factors “that suggest the Fed should keep raising rates.” To accept Ip’s forecast is to believe that these numbers concerning employment and capacity should be taken seriously.

Capacity utilization measures the percentage of estimated productive capacity in manufacturing, mining, and utilities in operation each month. The measure excludes services, and since services account for an expanding portion of U.S. economic output, it’s hard to be too concerned about the March number of 81.3 percent, which is 0.3 percent higher than its 1972 to 2005 average.

Aside from the reality that inflation is a monetary phenomenon that occurs exclusive of economic growth, Ip’s reasoning requires one to believe that the U.S. economy is isolated, activity within it static, and operating without integration in the world economy. Much as trade “imbalances” are irrelevant in what is increasingly an integrated world economy, so too are perceived labor and capacity shortages.

Indeed, with the continued penetration of 100 million-plus workers from the former Soviet Union, China, and India into the labor force, the notion of coming labor shortages seems pretty farfetched. Any discussion of the supply of labor must include the aforementioned countries, along with the rest of the world’s developing countries and their eager workers. The developed economies of the world will surely access these additions to the labor force, making the point about tight labor markets in any one part of the world moot.

It should also be remembered that just as the amount of available labor rises and falls here and elsewhere in response to marginal tax rates, workers respond to price signals in the market. If demand for labor outstrips supply, wages will rise and so will the number of available workers to depress wage pressure.

Regarding capacity utilization and assumptions about U.S. companies reaching arbitrary limits, it should be remembered that U.S. shoe and apparel maker Nike has never manufactured any of its products in the United States; that while airplane maker Boeing is based in Chicago, it will manufacture its 787 Dreamliner in six different countries around the world; that the design of Apple Ipods occurs in the U.S., but the components necessary to create the Ipod are imported. In other words, while U.S. companies design their products here, they access the world for capacity, making any domestic capacity measures irrelevant.

Domestically, it has to be remembered that as opposed to being static, capacity is ever changing. Be it through the expansion of existing plants, the introduction of robotics, or innovation that expands output from existing facilities, capacity is a fluid concept that should not be measured in terms of the here and now.

It sometimes appears that the only ones left who believe in limits to growth are economic journalists, academics, and certain central bankers. While it’s still unknown what the Fed will do at its next meeting on May 10, it should be hoped that low unemployment and high capacity utilization are not cited as factors driving interest-rate policy one way or the other.

— John Tamny is a writer in Washington, D.C. He can be contacted at jtamny@yahoo.com.

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