Industrial Production Rebound Not Sustainable

Scott Anderson
Chief Economist
Bank of the West

The U.S manufacturing sector continues to expand against a backdrop of rapidly rising interest rates, yet the ISM Manufacturing Index dropped to just above the break-even level of 50 in September, which marks the dividing line between expansion and contraction. Based on this measure, the pace of the manufacturing expansion has slowed sharply since February and peaked way back in March of 2021.

This steady deceleration in the manufacturing expansion was the main reason analysts were caught off guard earlier this week when industrial production expanded at a healthy 0.4% in September. The consensus was for a much more moderate rebound of 0.1%. The increase was broad-based led by a 0.6% rise in mining output and a 0.4% advance in manufacturing output. The solid monthly increase drove the growth rate from a year ago up sharply to 5.3% from 3.9% in August and reversed a trend of slowing year-on-year growth since May.

Industrial Production Growth Surged in September

Looking at the granular industry level manufacturing data reveals much of the production increase last month was driven by sectors that have been plagued by supply chain shortages - computer and electronic products (+1.1%), electrical equipment and appliances (+0.9%) and transportation equipment (+0.8%). Manufacturers are working off order backlogs that piled up over the past six months on clogged supply chains bringing overall manufacturing supply into better balance with weakening demand. We expect this temporary surge of manufacturing production will quickly fade as order backlogs subside. The early read on October is that manufacturing activity slowed further this month. Both the Philadelphia Fed and Empire State regional PMIs for October are already in contraction territory, a strong signal that the industrial production rebound we saw last month is not sustainable in the face of continuing rate hikes, a strong dollar, and deteriorating global growth.

Supply Chain Constrained Industries Grew Rapidly

That global supply chains pressures have eased is evident in the Federal Reserve's Global Supply Chain Pressure Index. The index hit peak supply chain pressure at 4.3 in December 2021. Since then supply-chain pressures have steadily eased each month. The index stood at 1.05 in September which is below where it was in early 2021. Easing supply constraints are allowing manufacturers to increasing production, replenish inventories, and more quickly fill new orders.

Global Supply Chain Pressures Have Eased Recently

Manufacturing price pressures may continue to linger for a while longer, however. The capacity utilization rate – defined as the manufacturing and production capabilities that are currently being utilized – rose to 80.3% in September from 80.1% in August. The index has been at 80% or higher for five of the last six months and at 80.3% is 0.7 percentage points above its long-run average from 1971-2021. The elevated and rising utilization rate will make it more difficult to lower overall price pressures and could push the Fed to continue aggressively lifting interest rates.

Capacity Utilization Tied For 2022 High in September

We are forecasting industrial production growth will continue to moderate and then turn negative year-on-year in 2023 as the Fed's interest rate hikes slow consumer and business demand. Production should rebound slowly in 2024 as the Fed begins to lower rates with inflation approaching its 2.0% target. Bottom-line, don't be fooled by the September industrial production head fake, risks to the manufacturing outlook remain firmly on the downside.

Industrial Production Growth Will Continue to Moderate

To learn more, check out this week's U.S. Outlook Report.


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