The mother of all inventory corrections is not the same as re-stocking
Back in April I told you I anticipated an uptick in GDP in part because of changes in inventories – massive change in the inventories. At the time, I thought I was going out on a limb by suggesting we could see positive GDP numbers in Q3 and Q4. However, this is now the consensus. My calculations were not aggressive enough, if anything. The economy has definitely picked up considerably.
But, I am still worried about consumption growth because of the poor employment picture. I could see a scenario where we have a relapse into recession because of weak consumer demand which fails to justify an increase in output or inventories. And we are definitely seeing output rise.
As a result, I have written about the present business cycle as the mother of all inventory corrections. Erroneously, I suggested we were going to see a re-stocking of inventories. That’s overstating the case. What I meant to say was that inventories were being purged so much in the first half of the year that it would lead to GDP growth even in the absence of re-stocking. This is something I stated correctly in May.
Thinking about production as opposed to sales again, you have to look at inventories. The NBER is not fooled by inventory builds because they look at both industrial production and retail sales. But, since GDP is a pure production statistic, inventory builds distort the picture. For example, say your economy produces $980 worth of stuff one quarter that gets sold. But it also sells a lot of stuff, $20 worth, out of inventory. If next quarter, you need to sell just as much stuff ($1000), guess what, GDP growth goes up automatically (Remember, we are not talking about GDP, but GDP growth). The inventory purge means you are producing less to meet demand than you would otherwise need to. So, when comparing one quarter to the next, unless you purge just as much stuff or unless demand goes down, you need to produce more. Therefore, you get an automatic uptick in GDP growth.
This is what is happening now. The positive impact that inventories is having on GDP growth has to do with the fact that GDP growth is a first derivative statistic where even subtracting a less negative number is positive.
Let me give you an example to illustrate. Let’s say you are running a road race and you do a bunch of practice runs with a coach who docks you seconds for not keeping a consistent pace or having bad form. After your first run, he docks you 35 seconds. In the second run, you have the same time. But, you make a concerted effort to stick to your pace and form. So the coach docks you only 15 seconds. Your time is the same but you are now subtracting a less negative number. The net effect is a better time. That’s what is happening with inventories.
So, after a massive inventory purge in Q1 and Q2, inventories are set to add to GDP growth in Q3 and Q4 regardless of whether inventories are restocked or not.