Capacity utilisation and its relationship to inflation in the euro area

Capacity utilisation indicators are currently very high in the euro area, and close to their highest rates of the last 20 years. The most popular of these indicators, the rate of capacity utilisation in manufacturing (CU), having risen continuously over the past two years, stood very close to its all-time high in 2007 Q3, despite being slightly down from Q2. Likewise, other indicators of the extent to which installed production capacity is being used and, generally, of the degree of slack in the economy, are at levels which appear to show that it has fallen significantly. The demand pressures implied by the developments described above may be signalling the emergence of inflationary pressures in the euro area. These circumstances have been alluded to on several occasions this year by the ECB, which has been highlighting the existence of upside risks to medium-term price stability related to the ongoing improvement in euro area labour markets (which may give rise to higher-than-expected wage settlements) and to the high rate of capacity utilisation. The recent path of euro area inflation, which has remained contained, indicates that these inflationary pressures have not as yet materialised. In the specific case of the CU, moreover, the empirical evidence available shows that its relationship to inflation is weak in the euro area and that in countries such as the United States, for which studies covering longer periods are available, it has weakened over the last two decades. The CU therefore seems to have lost predictive power with respect to inflation. Against this background, this article analyses the role of the CU in the set of information on which monetary policy decisions are based. The second section contains a descriptive analysis of the recent behaviour of measures of the rate of capacity utilisation in the euro area. The third section reviews the empirical evidence on the relationship between the CU and inflation, and the fourth section analyses what factors may have given rise to the change that seems to have been detected in that relationship and, more importantly, how they may affect its relevance as a useful indicator for monetary policy. Finally, the conclusions are set out in the fifth section.