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Saturday, March 25, 2006

The Relationship Between Manufacturing Production and GDP

After posting this graph showing the relationship between industrial production (IP) and GDP, I was made aware of research on this topic by Charles Steindel appearing in the New York Fed's August 2004 issue of Current Issues in Economics and Finance. In examining the graph I posted, it is difficult to see any change in the relationship between IP and GDP over time. This paper shows that a change in the trend relationship between the two series since 2001 is detectable when the series are put into a comparable basis (basically, manufacturing IP vs. the goods component of GDP) and offers reasons for the break in the relationship:

The Relationship between Manufacturing Production and Goods, by Charles Steindel, NY Fed: The sharp divergence in the 2001 recession between two key economic indicators—manufacturing production and goods output—could suggest that one indicator is flawed, casting doubt on the reliability of its overall series. This analysis finds no evidence of error. Rather, the strength of spending on consumer—relative to capital—goods and the growth of merchandising services in the sale of consumer goods more likely explain the recent deviation.

A curious phenomenon of the 2001 recession was the sharp divergence between two arguably similar economic indicators: the manufacturing component of industrial production and the goods output component of GDP.1 Adding to the peculiarity is the fact that the indicators’movements were much more alike in the previous recession, 1990-91.

Beginning in mid-2000, manufacturing, or "factory," production experienced significant declines. ... In the year and a half that followed, production grew very little. ... The GDP data tell a different story. The 2001 downturn witnessed virtually no drop in overall GDP, and there has been substantial growth since then. ... GDP encompasses more than just manufacturing activity, so it may not necessarily move in step with manufacturing production.2 Within the GDP data, however, is a series—goods output—that measures U.S. production of goods. The ... series, which accounts for about 40 percent of GDP, measures the same type of activity as manufacturing production does. Yet this series, like overall GDP, has behaved quite differently than the factory output numbers in recent years...

The recent divergence of these two sets of data raises a pertinent question... Namely, are manufacturing production and goods output measuring the same type of activity? If they are, their separate paths could suggest that one indicator has been in error and thus cast doubt on the reliability of the overall industrial production or GDP number.

In this edition of Current Issues, we investigate the reasons for the varying paths of manufacturing production and goods output during the most recent recession—and the possibility that one series has missed the mark. ... Our investigation yields no evidence of error in either series. ...

Having rejected the possibility of indicator error, we argue that the divergence between goods output and manufacturing production in the 2001 recession and subsequent recovery stems largely from two interrelated trends: the strength of spending on consumer goods relative to spending on capital goods, and the growing importance of merchandising services... Since the output of service sector workers ... is counted in goods output but not in manufacturing production, these trends very likely helped buoy the goods output figure during the recession and beyond.

Manufacturing Production and Goods Output
Manufacturing production is a robust measure of the value-added of factories. ... The other measure we examine, goods output, cumulates spending on goods in the United States by households, businesses, and governments ... plus exports of goods less imports of goods. At first glance, this concept appears quite similar to manufacturing production: U.S. spending on goods other than imports seems much the same as spending on goods produced in the United States, which in turn should be equivalent to the output of American factories.

In truth, however, there is a striking difference between the two measures (see box). ... a major distinction between the two indicators is the inclusion in goods output of the domestic service content of retail spending, whether the consumer good is made in a U.S. factory or abroad. ...

Long-Run and Cyclical Behavior of the Two Measures
Although manufacturing production and goods output differ conceptually, the two series may typically grow and shrink together. If so, the divergence in recent years may have been ephemeral...5 To explore this possibility, we study the relative behavior of the two aggregates over the long run and during key business cycles. Since the aggregates do not encompass the same menu of products, we begin by making the two series as comparable as possible...

We can now compare movements in the two adjusted series over the long term (Chart 1). Since 1972, goods output has consistently grown more strongly than manufacturing production—at an average rate of 3.5 percent, compared with 2.6 percent...

Chart 1 Goods Output and Manufacturing Production over the Long Run

Sources: U.S. Department of Commerce, Bureau of Economic Analysis; Board of Governors of the Federal Reserve System; author’s calculations.

The adjusted data suggest that in the typical cycle, manufacturing production drops more rapidly than goods output in a recession and rebounds more slowly in a recovery—with the major exception being the early 1990s. We illustrate this point in Chart 2, which shows the cyclical movement of the two series with their values at cyclical peaks (the 1980:1 peak is omitted). ...

Chart 2 Goods Output and Manufacturing Production in Cyclical Downturns

Sources: U.S. Department of Commerce, Bureau of Economic Analysis; Board of Governors of the Federal Reserve System; author’s calculations.

Note: The shaded areas indicate periods designated national recessions by the National Bureau of Economic Research.

This cyclical comparison suggests that the more peculiar experience is not that of 2001 but that of 1990-91, because the swing in goods output was then comparable to the swing in manufacturing production. In view of the other episodes, it was unusual for a manufacturing cycle of the magnitude seen in the early 1990s to have been associated with such a significant swing in goods output; goods output is typically much more stable than manufacturing production. ...

The Role of Service Inputs
Goods output incorporates all of the service sector activity associated with the sale of goods. The higher long-run trend of goods output compared with manufacturing production suggests that the relative importance of the service inputs to the sale of goods has been growing. In this part of our analysis, we consider two factors that may have combined to account for this growth: a shift in spending to goods whose purchase price incorporates a higher fraction of U.S. service input and an increase in the service inputs to goods in general.

As we have observed, an imported good requires some U.S. service sector inputs in order to be sold. Thus, the growth of trade and, in particular, the rising significance of imports have, all things equal, likely elevated goods output relative to manufacturing production,7 Although the greater importance of trade does not by itself represent a change in the fundamental service intensity of goods sold—imported shirts, for example, do not require more selling effort by retailers than do domestic products—the trade factor can be viewed as a spending shift to more service-intensive goods.

One can also argue that there has been some increase in the underlying service intensity of a major portion of goods output. ... Since the early 1980s, retail output has grown more rapidly than consumer spending on goods (Chart 3). This phenomenon suggests that the service component of goods output over the long run has increased for reasons other than the mere rise in the import share of purchases.8

Chart 3 Retail Output and Consumer Spending on Goods

Source: U.S. Department of Commerce, Bureau of Economic Analysis.

Notes: The data do not incorporate the recent benchmark revisions to the National Income and Product Accounts because the longer term GDP by-industry data have not been updated; thus, they end in 2002. The revisions appear to have had little effect on the consumer goods data.

The Role of Spending
As we have suggested, the divergence of manufacturing production and goods output over recent decades likely stems from long-run forces such as the increasing importance of foreign trade and the growth in service inputs to the sale of consumer goods. Yet such long-run forces may not play a role in a sharp short-term divergence like the one in 2001. In particular, trends in the fundamental service intensity of the marketing of individual products seem unlikely to vary much with short-term swings in the economy. ... The cyclical divergences may owe more to swings in the composition of goods demand and to differences in the sale and production of major categories of goods.

In particular, as Table 3 shows, recessions see greater declines in capital spending than in consumer spending. Indeed, in two of the last four recessions of any length (we exclude the extremely brief 1980 downturn), consumer spending on goods was higher at the end of the downturn than at the beginning. In addition, in three of the recessions, the drop in real spending on capital goods was at least 5 percentage points deeper than the change in spending on consumer goods. The exception is 1990-91...

Table 3 Changes in Consumer Goods Spending and Capital Goods Spending during and after Recent Recessions

Period Consumer Goods Capital
Goods
Recession
1973:4-1975:1
-2.2
-9.5
1981:3-1982:4
0.6
-9.7
1990:3-1991:1
-1.5
-3.4
2001:1-2001:4
4.2
-8.4
First year of expansion
1975:1-1976:1
5.9
1.8
1982:4-1983:4
7.5
20.3
1991:1-1992:1
2.4
1.5
2001:4-2002:4
2.5
1.6

Source: U.S. Department of Commerce, Bureau of Economic Analysis.

Why should the relative strength in consumer spending affect the relative performance of goods output and manufacturing production? As we have observed, consumer goods appear to require a higher fraction of service inputs to bring to market than do capital goods. A decline in production associated with a drop in spending on capital goods may involve less of a drop in related service sector inputs (and thus in overall goods output) than does a comparable decline in spending on consumer goods. ... the 1990-91 recession was atypical because the consumer share of the spending decline was unusually high.

Chart 4 Goods Output, Manufacturing Production, and the Composition of Private Demand for Goods

Chart 4 - Goods Output, Manufacturing Production, and the Composition of Private Demand for Goods

Sources: U.S. Department of Commerce, Bureau of Economic Analysis; Board of Governors of the Federal Reserve System; author’s calculations.

Note: The shaded areas indicate periods designated national recessions by the National Bureau of Economic Research.

a Excludes software.

Chart 4 illustrates the performance of goods output relative to manufacturing production and consumer spending relative to private goods spending (spending on consumer and capital goods) during the periods around the last four recessions. ... it appears that in periods around recessions, gains in goods output relative to manufacturing production may be connected to gains in consumer spending relative to capital spending.

Conclusion
Despite their apparent similarity, manufacturing production as an indicator of U.S. factory output is a different measure than goods output... Goods output has been growing relative to manufacturing production for many years. We attribute the growth in part to the rising significance of imported goods as well as to increased service inputs to the sale of all goods, whether manufactured in domestic or foreign plants.

The two indicators have also been affected by the relationship between spending on capital goods and on consumer goods. Compared with capital goods, consumer goods appear to require a larger share of post-factory ... service inputs to bring to market. Recessions generally result in much larger declines in spending on capital goods—and in manufacturing production of these goods—than on consumer goods, and goods output typically is more stable than manufacturing production in cyclical downturns...

The differences between the two most recent downturns suggest that the relationship between the overall economy and these two key indicators of economic activity can fluctuate, reflecting changes in the nature of demand and in the corresponding magnitude of the inputs outside the factory gates used to produce goods. Accordingly, while goods production is a crucial part of the economy, much of this output takes place outside the factory gates. Researchers who analyze only the manufacturing production data therefore have a limited view of the overall goods production process.

    Posted by on Saturday, March 25, 2006 at 11:54 AM in Economics | Permalink  TrackBack (0)  Comments (7)

          

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