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Chart Of The Week: Capacity Tightening

By Callum ThomasMarket OverviewAug 22, 2021 12:11AM ET
www.investing.com/analysis/chart-of-the-week-capacity-tightening-200599569
Chart Of The Week: Capacity Tightening
By Callum Thomas   |  Aug 22, 2021 12:11AM ET
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Most people agree that a lot of the inflation we are seeing right now is sort of short-term in nature e.g. base effects, pandemic disruption. But there is something else going on, and if you’re not careful you could easily miss it…

The recession of 2020 was familiar in some respects, and completely alien in many other respects. We basically turned the global economy off, and then switched it back on again.

This created what I would say is the illusion of an output gap.

Developed Economies - Tightening Capacity
Developed Economies - Tightening Capacity

The chart above shows a GDP-weighted composite of labor market and industrial capacity utilization across the major developed market economies. The lower it is the more spare capacity there is: aka “output gap." The higher it is the tighter capacity is, and all else equal—the greater underlying inflationary pressure there is.

That last comment is important: the reason we care about the black line in this chart is that if it goes really high then we should expect prices to rise as demand for productive capacity exceeds supply (as a side note, we should also expect firms to boost capex too—a virtuous circle).

The key point is that while we are currently experiencing very real and significant short-term inflationary pressures, much of it is likely to be just that: short-term. But as capacity utilization tightens up, we should expect to see more enduring, underlying, medium-term inflationary pressures emerge.

As we know, the market likes to go to extremes: when the current short-term inflation pressures inevitably start to recede the market will likely get carried away on the disinflation/deflation story… But if I am right in my thesis here, then subsequently more medium-term, underlying inflation pressures will start to pickup. So one implication or caution is not to get sucked into the deflation story when and if headline measures of inflation start to rollover.

The other big implication is for central banks: we’ve already seen EM central banks turn the corner on policy—if we start to see more underlying/core inflation pressures show up, it will be very hard for the more mainstream central banks to ignore. Some have been sucked into the illusion that central bank easing is here to stay, but it is not: it is cyclical. And if charts like the above are anything to go by, we will likely soon be reminded of that fact.

Bottom Line: Capacity utilization is tightening, that’s likely to mean a second wave of more underlying inflation pressures as we move through the cycle; and ultimately will mean more central banks will pivot from easing to tightening.

Chart Of The Week: Capacity Tightening
 

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Chart Of The Week: Capacity Tightening

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