4. Industrial Production and Capacity Utilization

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Introduction to Financial Markets

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Indian School of Business

Introduction to Financial Markets

783 ratings

Course 1 of 5 in the Specialization Financial Markets and Investment Strategy

Learn the general concepts of financial markets and economy. You will see the difference between primary and secondary markets and learn about markets for different products. You will also look at various economic Indicators and their influence on the markets. After completing this course, you will have a much stronger background of financial markets and ready to go to the next stage in the Specialization. This course is designed to help students with very little or no finance background to learn the basics of investments.

From the lesson

Macroeconomic Fundamentals

This module focuses on key economic indicators that are monitored closely by the finance community. You will learn to examine these economic indicators in the context of business cycles.

1. Jobs report : Country's fuel6:13

2. Consumer Confidence Index (CCI) : How confident are you?8:41

3. GDP : The back bone of the economy6:53

4. Industrial Production and Capacity Utilization7:57

5. Consumer Price Index (CPI) : Fixed income investor's enemy8:20

6. Producer Price Index (PPI) : A must know4:43

Meet the Instructors

Vaidya Nathan
Lecturer
Finance

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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.

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