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.
Recent manufacturing reports do seem to confirm what you describe, in that at the very least there must be less inventory drawdown to fulfill sales (even if there is not necessarily inventory building). What still surprises me is that there is a need to move beyond inventory drawdown at all given the inventory to sales ratio only being halfway back to trend (though the data is only through July). Now clearly this is just an aggregate measure and the distribution across companies will mean that many have already purged inventory while others have way above the average. If so, this might mean we are only at the leading edge of this effect (which would be very bullish for several quarters, unless sales slump significantly!) Do you have a different explanation for recent activity in the face of a still high ISRATIO?
I think that’s another statistical artifact. When you use a ratio, it doesn’t measure the absolute amount, so if the numerator and denominator both go down, the ratio can stay the same.
We know that output has gone way down. So, if inventories go down in proportion (keeping the ratio constant), on an absolute level they are low.
That’s the same thing that’s happening in the housing market ie there are 10 months unsold inventory but the sales number has plummeted.
The question is what is a ‘normalized’ output number. that’s what manufacturers grapple with – should I raise output to meet anticipated normal demand or is this new lower demand level what I should expect going forward?
You may be right but I find it peculiar that a statistical artifact would follow such a smooth trend, so I think there is some meaningful explanation for it, whether or not it is relevant to your post. And yes I understand the implication of it being a ratio impacted by both numerator and denominator. The underlying report shows sales having fallen 17.8% y/y and inventories only 11.8% y/y — so sales falling faster than inventories is clearly the key to why the ratio jumped in 2008 (and the ratio has been falling since as inventories are reduced relative to sales).
Inventories represent on average only a little more than a month’s worth of sales yet inventories have been getting reduced since late 2008, meaning most sales have been flowing through to generate new production each month (i.e. only a minority are filled from inventories that are then not restocked)… I think I need to play with the data a bit more but I do still think your point is still valid.
Really good analysis and explanation. Plus it will take a while till consumption ticks up. All that private debt (to pay down), the return of a positive savings rate in America, and the prolonged high unemployment rate while the economy itself restructures/shuffles around resources – takes time. I think we can’t see a real positive outlook for ‘the people of America’ till the end of 2010. Its long from over.
michael, good to hear from you in the comments! What you say about no positive outlook until the end of 2010 rings true. The technical recovery is (probably) here now but we won’t get back to where we were when the recession began in Dec 2007 for a long while. So, it’s not going to feel good for a while.
But, you know, even Ben Bernanke is saying this now. And the contrarian in me gets nervous when everyone is piling into the same trade.