Has excess capacity abroad reduced U.S. inflationary pressures?

Federal Reserve Bank of New York - Quarterly Review, Summer-Fall, 1994 by James A. Orr

WHILE U.S. manufacturing capacity utilization has been rising in recent years, capacity utilization in the manufacturing sectors of the major foreign industrial economies has declined. Falling utilization rates abroad have given foreign firms the potential to expand production without incurring significant cost increases. This article investigates whether sizable slack abroad, which has helped to slow foreign inflation, could also have eased U.S. inflationary pressures by preventing the prices of imports from rising as fast as the prices of U.S.-produced goods.

The analysis shows that growing foreign excess capacity has provided only a limited amount of protection against domestic inflationary pressures. Although inflation abroad has been lower than U.S. inflation, exchange rate changes have exceeded the inflation differentials and exerted significant and varied influences on import prices. For example, dollar depreciation against the yen has erased the depressing effects on prices of significant excess capacity in Japan, while dollar appreciation against the Canadian dollar has greatly enhanced the effects of moderate excess capacity in Canada. Aggregated across all sources, import price growth has roughly kept pace with U.S. inflation. Moreover, in U.S. manufacturing industries nearing full capacity, imports have not seized an increasing share of the market, a development that one would expect if foreign excess capacity were going to influence U.S. pricing decisions significantly. Consequently, the analysis concludes that the mere presence of excess capacity abroad has not greatly restrained U.S. inflationary pressures.

SLACK CAPACITY ABROAD AND IMPORT PRICES

Excess capacity abroad would relieve inflationary pressures in the U.S. economy if foreign suppliers, responding to growing U.S. demand, used their available capacity to expand production without increasing their prices significantly.(1) Import prices that remained flat or rose more slowly than the prices of domestically produced goods would slow U.S. inflation in two ways: directly, as the imports entered into U.S. consumption, and indirectly, as the imports siphoned off increases in U.S. demand and thus restrained price increases by competing U.S. firms.(2)

A significant amount of excess capacity exists in the manufacturing sectors of Japan, Canada, Germany, France, Italy, and the United Kingdom, countries that together account for more than one-half of all U.S. imports. Although aggregate foreign manufacturing capacity utilization in these economies increased slightly in the first half of this year, it declined more than 10 percent between the end of 1990 and the beginning of 1994 (Chart 1). In two previous downturns, capacity utilization abroad reached even lower levels, but the decline for the past several years is particularly notable because it occurred as U.S. capacity utilization was rising sharply.

The available evidence shows that growing excess manufacturing capacity abroad, among other factors, has exerted downward pressure on the prices of foreign manufactured products expressed in local currency.(3) Foreign producer prices have risen more slowly than U.S. prices. In fact, producer prices in Canada and Western Europe have lagged growth in U.S. producer prices by roughly 2 percent since the end of 1990 (Chart 2). During the same period, Japanese prices have lagged U.S. price growth by almost 10 percent.(4)

Nevertheless, although excess capacity abroad has helped to lower the local currency prices of foreign manufactured goods relative to U.S. prices, other factors affect the U.S. dollar price of imports--specifically, changes in the exchange rate and the extent to which these changes are passed through by foreign suppliers to U.S. consumers.(5) Movements in the nominal value of the dollar against the currencies of key industrial countries have far exceeded the moderate slowing in their producer prices relative to U.S. producer prices. Since the end of 1990, the dollar has appreciated more than 15 percent against the Canadian dollar and 16 percent against an average of Western European currencies, while depreciating 25 percent against the Japanese yen.(6) Dollar appreciation against the Western European and Canadian currencies has thus augmented their modestly lower inflation rates; by contrast, dollar depreciation against the yen has more than offset Japan's sizable decline in producer prices relative to U.S. producer prices.

Direct evidence on the prices of manufactured imports from industrial countries compared with U.S. producer prices between the end of 1990 and mid-1994 bears out the significance of exchange rates for import price movements (Chart 3). Even with only part of the change in nominal exchange rates being passed through into import prices, exchange rate movements largely undercut the potential benefits of relatively lower inflation rates abroad. From 1990 through the second quarter of 1994, dollar prices of U.S. manufactured imports from Japan rose roughly 6 percent compared with the prices of U.S. manufactured goods. This rise was consistent with the combination of a 10 percent fall in Japanese local currency prices relative to U.S. prices and a 20 percent nominal appreciation of the yen. The exchange rate movement thus overwhelmed the potential benefits of Japan's excess capacity for U.S. inflation. The dollar prices of manufactured imports from Western Europe and Canada fell roughly 7 percent against the prices of U.S. manufactured goods, a decline that was much more than the relative fall in their local currency producer prices but consistent with their nominal currency depreciations of more than 10 percent.