[MUSIC] Learning goals, after watching this video, you will be able to understand and explain industrial production and capacity utilization and the effect industrial production and capacity utilization data has on the stock markets, bond markets, and currency markets. Industrial production and capacity utilization. Industrial production covers nearly everything that is physically produced in the economy and includes the making of cars, umbrellas, paper clips, medical equipment, steel, what have you. It makes no difference whether these two goods are for domestic buyers, foreign consumers, or get stocked as inventory. All that matters is how much industry is actually churning out in the economy. One reason why traders are so keen on following industrial production is that it reacts fairly quickly to the ups and downs of the business cycle. Capacity utilization rate is a deceptively simple and incredibly important data. Market participants look at how much industries in the economy are presently producing. And then compare that output with what they can potentially produce if the industrial sector was running at maximum capacity, at the maximum possible capability. This data is significant in three respects, at least three respects. Firstly, a nation's economic power is judged by its ability to produce goods when they are needed. It reflects the strength and flexibility of the industrial sector. Second, it is useful to know how under-utilized manufacturers are in case more output is needed in the future. Third, the capacity utilization rate has some predictive value. It's a good leading indicator of business investment spending and can warn of building inflationary pressures. Industrial production is like a window into the industrial part of the world. It differs from other economic indicators in one very important respect. It actually measures the changes in the volume of goods produced, that is industrial production doesn't take the price of these products into account. So, there is no need to worry about the distorting effects of inflation. So, that makes it a more purer measure of output so it corresponds more closely to the performance of real or inflation adjusted GDP. Manufacturing activity is highly sensitive to changes in interest rates and demand so it closely parallels shifts in the overall economy. Capacity utilization measures the amount of slack that is there in the economy. So let me give you an example. So let's understand this using a hypothetical example of a bike making firm. Let's say that this firm has a capacity to manufacture 500 bicycles a month, but is currently producing only 350. So it's operating at a capacity utilization rate of just about 70%. Now let's assume that the rest of the bike industry is operating at the same low level. So you can produce 500 bicycles, but you're producing only 350. So that's only 70% capacity utilization. And if we assume that the bike industries operating at the same low level under such circumstances getting spare parts I don't think should be a problem, right. Because there is likely to be a lot of extra bike tires, brakes, etc., available from suppliers. Nor would there be reason to hire additional workers or invest in new bike making machinery because there are not enough buyers out there to purchase what can already be easily produced because people are operating at 70% capacity utilization. But all this will change when demand surges, and the industry starts churning out bikes at close to 100% of its capacity, i.e., it's operating very close to its maximum capacity. If that feverish pace continues for an extended period of time, bike manufacturers will begin to experience shortages in parts. Prices for bike components will rise. As the cost of assembling bicycles accelerates, shoppers will see their price tags go up as well. They key lesson here is that as the industry gets closer to operating at full capacity, shortages in resources emerge. And this can generate inflation. High capacity utilization rates can also lead to new investments in factory equipments and planned expansions so that companies can increase output in the future. As you might guess, the capacity utilization rate for manufacturing typically climbs when the economy is vibrant, and falls when demand softens. So what effect does this data have on stock markets, bond markets, and currency markets? Stocks, industrial production is not one of those high profile indicators which are known to roil the equity markets. Strong production is generally considered to be supportive of stock prices because it signifies more economic growth and better corporate profits. The only concerns for stock investors is if higher production leads to excessively tight capacity and higher prices. Should this scenario emerge, stocks might react negatively to a jump in industrial output. What effect does it have on bonds? Should industrial production and capacity utilization jump by a greater than expected amount, this can prompt a sell off in the bond markets. This is particularly the case if utilization rates climb about 80%, a zone which can begin to drain resources, can create bottlenecks, and definitely accelerate inflation. On the flip side, slow production along with falling utilization rates could raise bond prices and lower interest rates because the threat of inflation would have subsided. Or the expectation that inflation would increase is much lower, and therefore bond prices will increase. Currency, normally currency markets react modestly to industrial production. Foreigners try to assess how production and capacity utilization will affect future inflation and interest rates in the economy. Because a jump in industrial output suggests faster economic growth, it can increase foreign demand for domestic currency, at the very least to prevent domestic currency from falling. [MUSIC]
