Written by: Anonymous

David Foster, over at Photon Courier, posted a very good point to my last posting on Capacity Utilization.

Bear in mind, though, that "capacity" is not really a hard number. I may have several machines that can perform a given job...when cap utilization is relatively low, I will use those that are most labor and/or energy efficient...but as utilization grows and these machines become fully busy, I start using the older & less-efficient ones--thereby creating higher labor/energy costs and consequent inflationary pressures.

David, this is a great point, and I only wish that I had seen it earlier. First, you are dead on with your comment. The cost to employ the incremental unit of capacity begins to advance as we get closer and closer to the magical number of 83 or 84%. At 77.8%, many hold that there remains first-rate capacity to dispatch. Where we begin to witness accentuated concavity is anyone's guess, I have heard discussions that suggest 79 or even 80%. (To be honest, this is one of the areas where I begin to lose appreciation for macroeconomics - each individual actor within the vast domestic economic space is unique and pontificating where the aggregate "averages" an increase in the increase of costs is akin to incantation.)

But, your comment invites some thoughts that combine the idea of Cap Util and a monetary policy that has become as accommodative as a two-dollar whore. As I have eluded to in the past, a historically low fed funds rate affects all rates, near and far, as the steepness in the yield curve fails to fully, or even at times partially, absorb the depression of near term structure.

This creates a lower cost of debt financing for all players, even those that fight for existence on the investment-grade frontier. But, for now, lets take a look at those who enjoy a solid credit rating, say mid-range investment grades.

This is where your point (of the introduction of less efficient machinery as available capacity shrinks) comes in. If my trabajo in a given organization is to allocate surplus funds (by surplus I mean cash available to the firm after all obligations, including dividends, have been met) I am more than likely going to engage in some NPV analysis. Now, as my firm's WACC falls (due to the reduction of the fed funds rate (FFR) which leads to a reduction in the risk-free rate (RFR) which leads to a reduction in the cost of my debt financing - credit spreads sympathize, especially within investment grades, with shifts in the yield curve, i.e., spreads don't blow out as the yield curve falls) the propensity for positive NPV projects to surface increases.

There is some speculation (I am not saying that I subscribe to this line of thought) that firms have recently been purchasing capital goods in an almost speculative fashion for a few reasons. First, they "know" that rates are "soon" to rise and second, they are facing the age-old conundrum of deploying otherwise dormant funds (everyone, including Microsoft, is scolded for excess cash reserves). The recent theory goes, a firm can do one of two things with this excess capital, a) hire or, b) purchase capital goods. Some speculate that firms have found justification, via reduced WACCs, to replace worn and inefficient equipment, as they believe that they can enjoy greater return on marginal capital introductions rather than marginal labor introductions (I have great employees already, and they are getting better and better at using this productivity-enhancing machinery, lets just get the capital equipment I have at the periphery replaced with some new razzle-dazzle stuff - and no fear, the NPV on this idea is positive, as my hurdle rates have never been lower, but I hear that time is running out!)

So, some speculate that we as an economy are actually adding net capacity to the system, and may even experience a decline in Cap Util rates over the short term. At the very least, we may be replacing worn and inefficient capacity, so if we begin to approach 80, 81%, we may find that firms are incurring no real increases in marginal costs.

This of course says nothing of the peril that may be waiting for firms in industries where overcapacity (telecom, airlines, autos) creates a situation where firms have no ability to pass on increased costs, as market share must be protected to maintain cash flows.