Changes in Inventories

So what’s the deal with inventories, anyway? You may have been wondering a bit about that in the wake of yesterday’s GDP report, in which inventory changes played such an important role; one-third of economic growth in the first quarter of 2005 was simply due to firms building up their stocks of inventories.

Studying inventory changes may not be the sexiest topic in the field of macroeconomics… but it turns out to be an extremely important one. That’s because a) inventory changes are notoriously volatile, and thus play a big role in variations in GDP; and b) inventory changes can sometimes give us some information about where the economy is headed. This chart shows the change in inventories in each quarter in recent years:

Clearly the most recent quarter stands out – it was the largest build-up in inventories since the middle of 2000, right before the economic slow-down. But what does it mean?

The subtlety about interpreting inventory changes is that there are different reasons that firms may increase their inventories: they may do it unintentionally, if they are over-optimistic about their sales forecasts and thus produce more than they can sell; but they may do it intentionally, if demand is growing, in order to keep a steady ratio of inventory-to-sales. To make interpretation even a bit more complicated, note that firms’ desired inventory to sales ratio has been steadily declining over time as inventory management gets better:

Looking over a longer time period we can tentatively identify episodes of both types (intentional and unintentional) of inventory accumulation.

Inventory growth in 1994 and 2000 heralded slowdowns in economic growth. But inventory growth in 1997 and 1998 was simply a function of businesses keeping up with rapidly growing demand.

So how should we interpret the inventory numbers from the first quarter of 2005? Were they a sign that firms sense that demand is growing, which might cause them to intentionally keep a larger stock on hand? Or were they an unintentional buildup in inventories that firms will have to undo next quarter by slowing down their production? Looking at other economic data right now gives us no reason to think that firms are expecting a strong surge in demand. Hence (despite the somewhat contradictory inventory to sales ratio, which is still quite low) my guess is that firms will probably try to slow production to reduce their inventories next quarter. And slower production, combined with possibly negative inventory growth, could spell a very low GDP number indeed for the second quarter. But we shall see.