What is capacity utilization, and how is it relevant?

Have you ever been on a flight where there was nobody on the plane, and you were like, “This is … weird”? Or have you been on a flight where everybody was on the plane, and seven toddlers just screamed for eight hours? What you were experiencing is capacity utilization of that plane: How much it is being used.

You can ask the same question about the entire U.S. industrial economy — how much we’re using the factories and the like that we have. Right now, we’re at 77.5%, according to the Federal Reserve, which calculates this number.

So … what does that mean?

“We have nearly 300 different individual measures of specific industries or aggregates of industries that we measure every single month,” said Aaron Flaaen, a principal economist at the Federal Reserve Board of Governors.

The Fed, with help from the Census Bureau, literally asks factories and mines across the country, “How much could you produce in a perfect world right now?” And then they ask, “Really, though, how much are you actually producing?”

A little bit of math later, and they have a percentage of how much of the country’s industrial capacity is being used.

“That typically falls somewhere in, like, the 70% range,” Flaaen said. “We’ve only ever pushed up beyond 90% for any period of time for manufacturing as a whole, you know, during times of war.”

And much like the airplane, you really, really don’t want to be at max capacity.

“Because when you get up close to — not just 100%, but close to 93% — that’s when price pressures really hit,” said Gary Hufbauer, a senior fellow at the Peterson Institute for International Economics.

He said when supply is at its limit, producers can jack up prices. 

“You get reliably more inflation,” he said.

But the capacity utilization numbers don’t show that right now, and yet we have some residual inflation in the economy.

“The Fed is having a harder time with the last mile of inflation,” said Diego Comin, a professor of economics at Dartmouth College.

Because it’s not that the industrial economy is maxed out like it was in the pandemic, it’s something else: labor costs, housing shortages, he said — things that are harder to grapple with.