Thursday, December 31, 2015

What are Inventories Telling Us?

One of the economic miracles of the holiday shopping season is that we all troop merrily off to retail stores fully expecting that they will display a large and varied selection of goods on their shelves. I went to a grocery store on the morning of Christmas Eve, with no doubt in my mind that I would be able to pick up an idiosyncratic list of last-minute items for holiday meals--and indeed, everything was there.

The category of "inventories" refers to  how much is sitting on the shelf somewhere, waiting to be used or sold. Tying up resources in holding inventories has a cost, and over time, information technology and transportation improvements have made it easier to use "just-in-time" processes for re-ordering that make it possible to hold smaller inventories. Still, the size of inventories reveals something about expectations for future business activity, and also whether those expectations were met. What's interesting is that for the last few years, inventories across the economy are on the rise. The figures below are from the ever-useful FRED data tool maintained by the Federal Reserve Bank of St. Louis. The underlying data is updated through October 2015.

Consider the ratio of inventories/dales in the retail sector first. Notice the gradual decline over timef from 1990 into the early 2000s, as information technology made it possible to hold fewer resources. Notice also that during the two periods of recession, inventories first spiked up, as retailers found themselves with unexpected stock on their shelves, and then plummeted, as retailers delayed re-ordering until they were fairly confident that the economy was growing again. Indeed, the sharp rise-and-fall pattern of inventories is a mechanism that causes a recession to last over time. Finally, notice that since about 2012, the inventory/sales ratio is on the rise.

The inventory/sales ratio for manufacturers has a broadly similar pattern: the slow decline after 1990, the spike and decline during the Great Recession; and an uptick--albeit a more recent and modest uptick than in the retailer inventory/sales ratio--during the last year or so.

Finally, here's the inventory/sales pattern for wholesalers, who stand between producers and retailers. Here, the inventory/sales ratio didn't drop by much from about 1990 into the early 2000s: apparently, lower inventories for retailers didn't mean less was being held back in the warehouses of wholesalers. However, there is a decline in the early 2000s, a truly striking spike during the Great Recession, and a much sharper recent upswing.

As with any story in economics, there can be multiple interpretations of these patterns, some happier than others.

1) The most obvious pattern is that retailers, manufacturers, and wholesalers all expect sales to continue rising in 2016. Indeed, business inventories in general are sometimes used as a way of measuring "business confidence."

2) A complementary interpretation is that with very low interest rates during the last few years, the costs of having supplies sitting around on a shelf waiting to be used is relatively low. This factor doesn't explain the timing of the more recent rises in inventories, but it explains why they might have rebounded at least somewhat since the end of the recession in 2009, compared with pre-recession levels.

3) The rise in inventories may also be a message that trimming inventories went a little too far back around 2005, and the pendulum is swinging back a little.

4) Finally, I wouldn't be fulfilling my duty to the inherent pessimism of economics if I didn't point out that the rise in wholesaler inventories during the year or two is very large by historical standards. This may be occurring just because the inventory/sales ratio for  wholesalers is different: for example, it didn't fall during the 1990s, and it spiked more emphatically during the Great Recession. But given when inventories pile up too substantially, it can help be part of a slowdown later, one hopes that wholesalers are not misleading themselves about about how much they are going to sell going forward.