Briefing.com: Economic View

Taking Stock of Inventory Restocking

Last Update: 19-Aug-09 15:05 ET

For the past few weeks, economists and analysts have been forecasting that an end to the current inventory reduction cycle is near. While the equity market does not tend to trade heavily on inventory data releases, the volatility of inventory changes plays a large role in estimating GDP growth.

Since the current inventory contraction has been one of the largest on record, a small increase in inventory stocks will cause its effects to be magnified. In fact, we believe GDP growth will turn positive due to inventory restocking and not by the typical consumer or fixed investment led recovery.

Since August 2008, inventory investment has declined 10.4%. At the same time, GDP has declined 3.0% on a non-annualized rate. The change in inventories contributed roughly 33% of the drop in GDP during this time period, more than both the decline in consumption (23%) and residential housing (31%).

Inventory Restocking and GDP Growth

The latest ISM manufacturing report showed the rate of inventory contraction may have bottomed out in the June. As the economic recovery becomes more secure, firms will expect demand to start increasing.

The inventory run-off should end within the next couple quarters and production will come back on-line to meet demand.

Since the contraction was so severe, any stabilization in inventories will result in large increases in GDP.

For example, if inventories held at current levels and posted no change over the next quarter, GDP would grow by roughly 4.8%. This would look like a strong recovery, but in reality production was just in maintenance mode.

Production in the aggregate does not stop contracting overnight, but even a 20% drop in the annualized contraction rate (5.4% non-annualized) will cause GDP to grow by roughly 1%.

How Does This Affect Employment and the Greater Recovery?

The big question is how the rebound in inventory growth will affect employment and the rest of the recovery.

Historically, the unemployment rate declines when GDP growth is above trend. However, the last two recessions were labeled jobless recoveries because unemployment lagged growth. An inventory change "recovery" will NOT alter the employment landscape.

The reason is simple. Current production can be maintained by current employment. GDP may grow above trend, but firms will not have any need for new hires.

Further, once inventories are in maintenance mode, the inventory bonus to GDP evaporates. The rate will again reflect continuing weakness in the consumer and investment sector. Don't be fooled into thinking the U.S. is in a strong recovery by positive GDP numbers if they are led by increases in inventories!

--Jeff Rosen, PhD, Briefing.com

Models of Inventory Investment

There are two main theories regarding inventory investment: production-smoothing and the (S,s) inventory model. Both theories assume a single firm maximizes its profits and inventory production is one of the firm's decision variables.

The production-smoothing theory begins with a producer that faces an increasing marginal cost curve. Sales change over time but costs remain constant. In order to minimize costs, the firm creates a production target that not only meets sales expectations but also creates a buffer stock of inventories. If sales are volatile, the buffer stock will allow the firm to hold off producing on an erratic and expensive schedule.

The (S,s) inventory theory begins with a firm that acts as wholesaler or retailer and does not actually produce the good. Marginal costs are constant and the firm faces a fixed cost with every order. As the order size increases, the average cost per good falls.

The firm would minimize its costs by ordering as many goods as possible. However, the firm would incur a loss of interest payments on funds used to purchase the inventory. Therefore the decision involves the creation of a buffer stock which reduces costs, but the stock level must be low enough so the firm can maximize its potential interest payments.

Current Inventory Contraction

Both inventory theories work at explaining the current economic environment. In the beginning of the recession, producers did not foresee demand falling quickly.

Remember, most economists and analysts thought the recession would be mild in their worst-case forecasts. As a result, producers maintained their production-smoothing techniques and wholesalers/retailers kept a stock pile of goods that met their needs.

As consumer demand soured through the beginning of 2008, both producers and wholesalers/retailers were sitting on large stockpiles of inventory.

The only way for the inventories to be liquidated was for consumer demand to pick up. Producers halted production to reduce their excess buffer stock and wholesalers/retailers did not put in for new orders of goods. The drop in production forced many firms to lower costs and layoff large portions of their workforce.