Is “High” Capacity Utilization Inflationary?

C apacity utilization in U.S. industry features prominently in discussions of inflation. This prominence derives from the widely held viewpoint that “high” rates of capacity utilization are tantamount to resourceshortage conditions or “bottlenecks” that inevitably erupt into price inflation. For instance, an article in Citicorp’s Economic Week (January 18, 1994) argues: “In the past, a utilization rate swinging up toward the 84%–85% range was a source of much anxiety. Usually when the rate got that high, production bottlenecks started to appear. . . . Shortages developed. And soon, key price indexes were shooting up.” In the American Banker (January 12, 1994), Stephen Davies points out: “Economists say that, historically, there has been a connection between a healthier industrial sector and rising prices. That’s because factories start to run into bottlenecks in which supplies and labor are short” (p. 1). And in an article in Barron’s (June 20, 1994), Gene Epstein states, “Capacity utilization should remain below 85%, the assumed inflationary danger zone” (p. 48). A concomitant viewpoint is that when capacity utilization is “low,” the economy is in the inflationary safe zone. The threshold defining “high” and “low” rates of capacity utilization is often 85 percent, as the above quotations exemplify. The purpose of the present study is to outline the theory underlying these popular views and to evaluate it in terms of its ability to explain the facts about the U.S. economy. To accomplish this task, the article proceeds as follows. Section 1 isolates and discusses the core features of the theory. Section 2 presents the evidence on the relationship between capacity utilization and inflation and related evidence on the linkage between cyclical GDP and inflation. Section 3 assesses the theory in terms of its ability to explain the evidence. Finally, Section 4 concludes with a summary and suggestions for future research.