The Manufacturing Slowdown Is No Manufactured Problem
The manufacturing sector is a much smaller portion of the American economy today than yesteryear, but it is still a leading indicator to the service sector, and therefore the broader economy. When it comes to timing a recession, manufacturing has proven to be a reliable gauge – at least for those still willing to pay attention to it.
When the Federal Reserve isn’t destroying the economy as fast as bureaucratically possible, the regional Federal Reserve banks are sometimes collecting very useful data, like surveys of manufacturers in their respective districts. The New York, Philly, Dallas, and Richmond banks all have similar methodologies in their surveys, so it’s easy to compare results across regions.
Each of these four banks has a monthly manufacturing index, derived from a matrix of inputs, designed to measure the health or activity level of the sector. The survey results are primarily a comparison of the number of respondents indicating a positive outcome versus a negative outcome.
For example, one of the employment components to the surveys asks respondents if their payrolls have increased, decreased, or stayed the same this month. The percentage of respondents with less employment is subtracted from the percent with more employment, and the result is one of the inputs in the overall matrix. If 50 percent of respondents had layoffs, while 25 percent hired more people, and the other 25 percent had no change, the value for overall employment for the month would be -25.
From a myriad of categories, including multiple employment measures, an overall value for general business conditions or overall manufacturing activity is calculated. Values above zero indicate growth from the previous month while values below zero indicate contraction. Here are the results since January 2021 along with an average of the four banks:
A few things jump out. First, New York’s index is very volatile relative to the others, but follows the same trend. If we use a 3-month moving average, it looks a little less like a seismograph on the San Andreas fault:
Now we can see the trends a little more clearly. Manufacturing was expanding at an increasing pace coming out of the 2020 government-imposed lockdowns, and the speed of expansion peaked the next year between May and September, depending on the region, so let’s call it the summer of 2021. Then the pace slowed – dramatically and quickly.
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Starting in the spring and by early summer of 2022, each manufacturing index went negative, meaning a contraction in the sector. The rate of decline has varied with Texas getting hit hard and fast while the Philly district took longer to see the fastest declines. The Richmond district never saw the fast contractions in the other three areas, but also never saw the same peak in growth. The Empire State has swung wildly between slight expansions and steep contractions, but overall has been shrinking markedly since the beginning of last year.
The average of the four banks shows the same pattern, bottoming in May of this year and crawling their way back up since then. Yet the recent increases in the indices are not indicative of growth, but merely a slower rate of decline. While the Richmond district’s latest value is positive and both the Philly district and Texas recently had positive values, these data points are unlikely to continue into trends.
Respondents in all districts today report increased difficulties ranging from a drop in demand, to tighter credit conditions and higher financing costs, to the recent reacceleration of inflation. And we have additional data from two more regional Fed banks that point in the same direction.
The Kansas City Fed has a slightly different methodology for its manufacturing survey, but we can interpret the results in basically the same way: positive numbers show expansion from the previous month while negative numbers show contraction. The Chicago Fed is a different beast altogether. Positive numbers mean above trend growth while negative numbers mean below trend growth. At some undefined negative value, the index indicates contraction, but we don’t know what that value is. Sigh—only Chicago…
Both of these regional banks reported accelerating activity in their respective manufacturing sectors as 2021 began, but those growth rates stopped increasing and then started declining. By the end of 2021, the Chicago district was dipping below trend and the Kansas City district dropped off about six months later, also falling below it’s long-run trend.
Manufacturing in the Kansas City district began contracting in October 2022, and hasn’t grown since then. In the Chicago district, growth fell below trend (whatever that means) in June 2022 and since then has had only one positive print in February of this year. We can get a sense of where the “break-even” point is for the Chicago index, however, by comparing it to the other five regional banks and by assuming that the Chicago district manufacturing sector roughly follows the larger national sector.
That would mean the Chicago district began contracting in either June or July 2022 (when the index went into freefall), and has bounced between expansion and contraction since then, much like the Empire State manufacturing sector.
So, what are these six regional Fed banks telling us? First, the easy part: looking backwards. The sector has clearly contracted, with production down and new orders falling off a cliff. Ordinarily, this would’ve resulted in massive layoffs, but manufacturers started 2021 with a huge shortfall in labor and a massive backlog of unfilled orders. Firms have been struggling to hire workers since then and still haven’t returned to their pre-pandemic trend.
Because businesses weren’t fully staffed, they haven’t had to fire many people to reduce production. They also had a massive backlog of orders to work through, which has sustained business even as new orders plummeted at rates never seen outside of the pandemic. The decline in manufacturing, therefore, has not been accompanied by several of the typical warning signs. Nevertheless, things have clearly deteriorated.
Firms are still struggling to pass their input costs on to consumers, profits are dwindling, and growth prospects have all but evaporated. Their backlogs of unfilled orders are all but gone, and there aren’t enough new orders to sustain current production or employment levels.
The second thing the regional Fed banks are telling us is that the broader economy will follow manufacturing into contraction within the next six months. Additionally, manufacturing is poised to decline further, albeit at a slower pace. The underlying data for all six indices point to further deterioration, just not as fast as the freefall seen in late Spring or early Summer of last year when each index bottomed out. The difference going forward will be that metrics like employment fall faster than production, the opposite of what we’ve seen thus far.
Here’s where things get hazy because they’re dependent on events that haven’t happened yet. If the appropriations fight in Congress results in considerably lower spending, we might avert a steep downturn, and a recession will be short and mild. That seems unlikely if history is any indication, which means the spending will continue out of Washington, and the coming recession has the potential to not only outlast the Great Recession but outdo it in magnitude as well.