The US production slip won't halt the Fed's plans

The decline in US industrial production during August is not a concern. And, with the Fed set to cut its asset purchases this month, a rate rise is getting closer.

Production eased during August, but the US economy remains healthy and should post solid gains in the September quarter.

Growth has picked up considerably after a soft start to the year, highlighting the resilience of the recovery and that the economy is well placed to end the year on a high.

In the US, industrial production fell by 0.1 per cent in August -- following strong gains over the previous six months -- to be 4.1 per cent higher over the year. The result missed market expectations for a moderate rise in activity.

Manufacturing production -- the biggest subcomponent -- fell by 0.4 per cent in August to be 4.0 per cent higher over the year. The weaker result follows a surge during July, which was boosted by motor vehicle production.
Graph for The US production slip won't halt the Fed's plans

Mining and utilities expanded by 0.5 per cent and 1.0 per cent, respectively, in August. The utilities sector has been hit in recent months by what has been a remarkably mild summer across the US, punctuated by the absence of lengthy heat waves. As a result, the demand for air conditioning and utilities in general has been fairly weak.

Despite the weaker result, industrial production has been much stronger this year and last, with annual growth sitting at above 4 per cent during the past four months. Last year averaged annual growth of just 2.9 per cent.

There’s also reason to be optimistic about the manufacturing sector. According to the Institute for Supply Management, manufacturing activity rose at its fastest pace since 2008 during August.

Production should also be underpinned by improving domestic demand. Retail sales, for example, rose by 0.6 per cent in August and finally appear to be generating some momentum after a lacklustre start to the year.

But there is still considerable room for improvement -- a point made frequently by the Federal Reserve -- and that can be seen easily by the rate of capacity utilisation. Measures of capacity utilisation remain below their pre-crisis levels, indicating that there remains significant spare capacity across the US economy.
Graph for The US production slip won't halt the Fed's plans

For the labour market, this is materialising in soft wage growth and has left employees in a poor bargaining position. Until recently, this has resulted in softer-than-expected growth in household spending and moderate inflation.

For businesses, it highlights why there has been a reluctance by many companies to expand investment. When you are not utilising the factories you have, why build more?  

The Federal Reserve meets this week and will cut its asset purchases by an additional $US10 billion. The Fed is all but certain to end its purchasing program when it meets in October.

At its meeting over Tuesday and Wednesday, the Fed will be looking to provide the market with further forward-guidance on when to expect a rate hike. Right now expectations are for the first half of next year but the Fed needs to highlight that this is data dependent and could happen sooner if the US labour market resumes its recent momentum.

Although the most recent labour data was unexpectedly weak, the general view is that the recovery continues to firm and that spare capacity is gradually being absorbed across the broader economy. The unemployment rate is at 6.1 per cent -- having improved by 1.1 percentage points over the past year -- and measures of inflation have increased moderately towards the Fed’s upper target of 2 per cent annual growth.

The bottom line is that the US economy is no longer sufficiently weak to justify leaving rates at the zero lower bound for a considerable time. The Fed will no doubt be cautious -- as it has been throughout the recovery -- but with its asset purchases set to end next month, the time is right to get the market ready for a rate hike.

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