Ed Peters
November 6, 2020

The global economy has recently showed some signs of stabilization, particularly in the manufacturing sector. Unfortunately, there seems to be a significant amount of misunderstanding of what Purchasing Managers Indices (PMIs) from ISM and MARKIT represent. For instance, a Reuters headline declared, “US manufacturing near two year high” after the most recent release of the ISM US PMI. Yet, the Fed’s latest estimate of capacity utilization (how much manufacturing potential is being used) stands at 71.1% -- roughly the lowest it’s been since March 2010. How can manufacturing simultaneously be near a two-year high and a 10-year low? The reason is that while the two indices both measure manufacturing, they represent different things. One is measuring growth; the other is measuring levels. It’s important not to confuse the two.

The PMI, according to MARKIT, is “a survey-based economic indicator designed to provide a timely insight into changing business conditions in the goods-producing sector.” MARKIT and ISM survey purchasing managers about a number of conditions and ask if current conditions, since last month, have (A) improved, (B) stayed the same, or (C) gotten worse. The index is then constructed by taking the percentage of total respondents who respond A, B or C and weighting them:

Index = 100*(1.00*(percentage who respond A) + 0.50*(percentage who respond B) +0.0*(percentage who respond C))

So if all the managers surveyed respond A, then the index would equal 100, meaning that 100% or those surveyed say things are improving. If they all answer B, then the index would read 50. Because the ending index is a weighted average, manufacturing is commonly interpreted as expansionary if the index is above 50. The higher it is above 50, the higher the conviction that the expansion is strong and/or wide-spread. 50 means stagnation, and below 50 signals a contraction. So the PMI is about the growth rate, not the level of economic conditions. Historically, it has ranged from a low of 35 to a high of 61. By construction its “neutral” reading is 50, though its average is closer to 52.

Capacity utilization is a measure of the level of economic activity. When the capacity utilization gauge reads 70%, it means that 70% of our resources to manufacture are actually being used. The more capacity is being used, the higher the demand for goods. Capacity utilization has ranged from a low of 65% to a high near 90%, and it averages around 77%.

Figure 01 below shows how these two types of indicators are related. So that things are comparable, we will use US Capacity Utilization calculated by the US Federal Reserve and the ISM US Purchasing Manager Index from January 2000 – September 2020.

(January 2000 - September 2020)

Sources: St. Louis Fed, Datastream

Capacity utilization is on the left axis while PMI is on the right. We can see that the PMI is indeed close to a two-year high, as Reuters claimed. In October, 59.4% of purchasing managers said things are getting better vs. 50.1% in February. That’s good news!  Unfortunately, the capacity utilization numbers are not quite as optimistic. We can see the plunge in the US economy when lockdowns began earlier this year, with utilization falling from 76.9% in February to 64.2% in April. The good news is that as businesses reopened, capacity use did improve to 71.1% in September – but that still only regains about 57% of the loss in capacity use that occurred in March and April. To give 71.1% context, you’d have to go back to March 2010 to find capacity use at such a low level.

So while it is indeed good news that manufacturing has rebounded, it still has a long way to go to get back to pre-pandemic levels. As we can see in the above graph, capacity use is actually beginning to fall back off again, so don’t be fooled by the media treating PMI as a level of economic activity.  It’s really a measure of growth and momentum. To judge the level of economic activity, look to numbers like capacity utilization.

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