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An Immoderate Inventory Cycle

The final estimate of fourth-quarter real GDP growth registered 5.6 percent, but was revised down from the second estimate of 5.9 percent. It was, nevertheless, substantially higher than the 2.2 percent pace recorded in the third quarter. To better understand the apparent strength in fourth quarter activity, it is instructive to split GDP into two basic components: final sales of gross domestic product and the change in private inventories. Because GDP measures the flow of output produced during a given quarter, the portion of product unsold at the close of the quarter is counted as an investment in inventories. Final sales represent everything else and include all of the familiar expenditure components (consumption, investment, net exports, and government purchases) and their subcomponents.

A look at each component shows that the developments in inventories were responsible for the apparently strong fourth quarter of 2010. Although firms cut inventories as in the preceding quarter, they did so less severely, so that inventory investment actually added 3.8 percentage points to growth. Final sales rose at moderate 1.7 percent pace, up slightly from the 1.5 percent rate posted in the third quarter, and contributed the remaining 1.8 percentage points to fourth quarter GDP growth. In sum, fourth quarter strength was the result of inventory liquidation happening at a slower pace than in the third quarter. In situations like the current one, final sales growth renders a clearer signal of the underlying strength of the economy. We are surely recovering from the Great Recession, but not nearly as rapidly as suggested by the latest GDP figure.

If ordinary intuition is vexed by inventory logic, then some basic arithmetic may help clear it up. In the table below, the second column gives the value of inventory investment in each quarter during the 2007-09 period. A positive number signifies an accumulation of inventories—or production in excess of sales—and a negative number indicates a decumulation (sales in excess of production). The third column shows the value of the stock of inventories present at the end of the indicated quarter—in other words, the value unsold cars on lots, oil in storage tanks, grain in silos, and a myriad of other goods in warehouses and on store shelves. From the table, one can easily verify that the inventory stock in place at the close of given quarter is equal to the existing stock from the preceding quarter plus the amount of inventory investment during the quarter (divided by four since GDP component flows, including inventory investment, are reported at annual rates).

Contributions of Investment and Final Sales to GDP

nbsp; Inventory investment (billions of chain-weighted dollars) Inventory stock (billions of 2005 chain-weighted dollars) Change in investment (billions of 2005 dollars) Inventory contribution to GDP (percent) Final sales contribution to GDP (percent) GDP growth
2007:Q1 14.5 1828.8 2.6 −0.6 1.8 1.2
2007:Q2 23.3 1834.6 6.5 0.2 3.4 3.6
2007:Q3 29.8 1842.1 6.5 0.2 3.4 3.6
2007:Q4 10.3 1844.7 −19.5 −0.6 2.8 2.1
2008:Q1 0.6 1844.8 −9.7 −0.2 −0.5 −0.7
2008:Q2 −37.1 1835.5 −37.7 −1.3 2.7 1.5
2008:Q3 −29.7 1828.1 7.4 0.3 −2.9 −2.7
2008:Q4 −37.4 1818.8 −7.7 −0.6 −4.7 −5.4
2009:Q1 −113.9 1790.3 −76.5 −2.4 −4.1 −6.4
2009:Q2 −160.2 1750.2 −46.3 −1.4 0.7 −0.7
2009:Q3 −139.2 1715.4 21.0 0.7 1.6 2.2
2009:Q4 −19.7 1710.5 119.5 3.8 1.8 5.6

Source: Bureau of Economic Analysis and author’s calculations.

Published GDP growth rates typically compare the magnitude of real GDP in a given quarter with that of the prior quarter, with the growth rate subsequently annualized. As part of this calculation, inventory investment is naturally compared to the previous level of inventory investment. The quarter-to-quarter changes in inventory investment are reported in the table as well. The big push to GDP by inventory investment in the fourth quarter is now apparent. The change in inventory investment from the third quarter of 2009 to the fourth was a massive $119.5 billion increase, leading to the outsized 3.8 percentage point fourth quarter contribution from inventory investment—despite the fact the stock of inventories continued to fall. They fell, but at a much slower pace than previously.

Although the outsized 3.8 percent contribution from inventory investment in the fourth quarter is not without precedent, it is the largest since the first quarter of 1984 in the wake of the severe 1982 recession—just prior to the beginning of the period dubiously dubbed “the Great Moderation.” During that period, there were only two recessions, both mild and in which firms met with more success managing inventories. Perhaps in an exercise putting the cart before the horse, some economists championed better inventory control as a driving force behind the Great Moderation. Recent experience casts that conclusion into doubt. In either a failure to properly anticipate the dramatic collapse in demand, or to adjust production levels quickly enough, inventory slashing continued well into the second half of 2009, setting up the dramatic slowdown that led to the surprise contribution of inventory to GDP in the fourth quarter.

This raises the dual question: how much further will inventories fall in the coming months, and how fast will they fall? The answer depends largely on the present size of inventories relative to current sales. Because changing the rate of production is typically costly, inventories provide a useful buffer between production and fluctuations in demand, hence the fluctuations observed over the past few years. But carrying inventories is also costly.

Over time, firms will seek to match inventories and sales by striving to maintain a target inventory-sales ratio. By my own calculations, the ratio is roughly 4.3 percent below its trend in the fourth quarter. (The ratio I applied includes the final sale of goods only. The goods-only ratio produces a better benchmark or target since inventories naturally comprise only merchandise, whereas final sales of GDP also include services.) Interpreting the trend ratio as the target and applying historical rates of “error correction,” implies that the target ratio will be virtually restored by the end of 2010. If so, we can look for rising inventory levels soon, perhaps as early as the first quarter of 2010, along with another substantial positive contribution from inventory investment to GDP growth. Inventory contributions should revert to smaller, and more historically normal levels, in the second half of the year.

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