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September 16, 1983
Inventories and the Recovery
The recent increases in output and July's
one-half percent drop in unemployment
suggest that the recovery has begun in
earnest, despite persistently high interest
rates. The question now is how strong will
the recovery be? One importantdeterminant
of the strength and duration of the recovery
is the vigor with which businesses seek to
rebu i Id depleted inventories. A recent spot
survey of businesses in the West suggests
that firms are acting cautiously in rebuilding
inventories because they want to prevent
their stocks from growing at a faster pace
than the sales they expect over the short
term. This Letter examines the response
of Western firms to the beginnings of the
current upturn and the factors which will
help determine inventory investment as the
recovery progresses.
for by this negative inventory investment.
And although the recession officially ended
in the fourth quarter of 1982, nonfarm businesses continued to run down their inventories at a $1 5.4 billion annual rate in the first
quarter of this year, causing sluggish growth
in output despite a strong upturn in sales.
Inventoriesand the businesscycle
Whether firms will continue to step up production and add to their stocks of inventory
depends on their "bullishness" on the
economy. Expected demand is clearly a key
factor, but it must be weighed against current and expected levels of interest rates and
firms' expectations regarding their own
product prices which affect the cost of carrying inventory.
The high cost of adjusting production and
orders to every change in sales causes firms
to let inventories rise and fall inversely with
changes in demand. Inventory stocks tend
to rise above desired levels when demand
softens unexpectedly and to fall below desired levels when sales pick up. Inventories,
therefore, act as a,n important buffer stock,
allowing firms to respond to unanticipated
changes in the demand for their products.
However, when inventory stocks remain
above (or below) desired levels (relative to
sales) for any extended period, firms respond by cutting (stepping up) the pace of
production activity to bring inventories back
in line with current and expected sales. As a
result, changes in the level of inventories
contribute significantly to the peaks and
troughs of business cycles. For example, the
$32.9 billion (in 1972 dollars) decline in net
nonfarm inventory investment was a significant factor behind the recession which
began in the third quarter of 1981. Almost
three-fourths of the $45.1 billion drop in
output during the recession was accounted
However, firms now appearto be rebuilding
inventories, or at least not to be depleting
them further. Recent increases in sales,
therefore, should show up as further increases in production, giving a boost to the
nascent recovery. The $33.3 billion increase
in real G N P (a 9.2-percent annual rate of
growth) recorded in the second quarter, for
example, is due, in large part, to the dramatically slower pace of inventory liquidation
during that quarter.
Expectedsales
The current level of sales and expected
future demand appear to be the most relevant considerations in determining shortterm movements in' inventory investment.
To avoid any loss of business from short
supplies, firms try to hold sufficient inventory to cover most increases in sales that
might materialize. But firms must also pay
the carrying cost of holding inventories. In
general, they seek to minimize the cost of
holding inventories by gearing inventory
investment to current levels of sales while
taking account of seasonal patterns in
demand as well as any other factors that may
cause future sales to diverge from current
sales. Other things being equal (e.g., no
in
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working capital for investment in alternatives, such as high-yielding, short-term
financial instruments. A survey of western
firms tends to confirm this relationship as
most firms cited the high level of interest
rates as a reason for their cautious approach
to rebuilding inventories.
changes in the cost of carrying inventory),
firms typically try to keep the ratio of inventories to sales fairly stable, allowing the level
of inventory stocks to vary as current and
expected sales vary. Of course, if sales taper
off from a weakening of the economy, firms
will liquidate inventories to bring the
inventory-to-sales ratio back down to the
desired range.
More sophisticated empirical tests of the
relationship between inventory investment
and interest rates, however, have yielded
somewhat mixed results. Until recently, in
fact, most studies did not find convincing
evidence of any short-term connection
between the level of interest rates and inventory investment. More recent studies examining inventory investment during the current period of high and volatile interest rates
have tended to provide empirical support for
this relationship, however. The disparity
between the results of the older econometric
studies, on the one hand, and the recent
survey and the newer studies, on the other,
raises questions about the way in which
interest rates are assumed to affect inventory
investment. It may be the case, for example,
that inventory stocks respond lessto random
blips in interest rates than to changes that
seem part of a cyclical pattern. Since the cost
of changing the average level of inventories
is significant, business will wait to see
whether an increase in the level of interest
rates is likely to be long-lived.
The experience of western firms during the
last recession and current recovery is a case
in point. The process of inventory liquidation which began in earnest in response to
lagging sales in the first quarter of 1982 has
virtually come to an end in the nine western
statesthat constitute the Twelfth Federal
Reserve District. Inventories are currently at
their lowest levels in almost ten years, and
these low levels are considered desirable
despite evidence of a strengthening western
economy. Even firms that are experiencing
strong demand for their products-most
notably, electronics firms and retailers-are
waiting for evidence that strong sales will be
sustained. In general, most firms are rebuilding inventories very cautiously, relying not
on annual sales forecasts but on actual
orders or forecasts of sales no more than a
few months ahead.
As sales pick up, of course, these firms
expect to increase the level of their inventories. However, most intend to keep inventories "lean" in comparison to sales
primarily because of uncertainty about
future demand and the high cost of carrying inventory.
In addition to the impact of cyclical changes
in interest rates on inventory investment,
secular trends in the level of interest rates
have an impact on the level of inventory
investment as well. The upward trend in the
level of interest rates during the 1970s, for
example, induced many firms to try to exercise greater control over inventories in the
course of the business cycle. Of course,
firms will not perceive the advantages of
investing in new techniques or technology
that permit closer control of inventories until
they believe the level of interest rates is
likely to remain high enough to justify such
investment. But once inventory control has
been improved, a cyclical decline in the
Interest rates
In today's environment, one of the factors
that contributes to the high cost of carrying
inventory is the persistently high level of
interest rates. Like other forms of business
investment, theory indicates that, other
things unchanged, high interest rates will
have a negative effect on inventory investment. Firms presumably cut back on inventory stocks during periods of high rates to
reduce expensive borrowing or to conserve
2
level of interest rates will not have the same
effect on inventories that it would have had
formerly. The average level of inventories in
. relation to sales is likely to be permanently
lower despite a return to lower levels of
interest rates.
digit levels of the past few years, western
retailers plan to keep inventories lower than
they wou Id have several years ago.
Lessinventory investment
The pace of inventory investment in the
West in the next few years is likely to be
more anemic than in past recoveries. Firms
are attempting to keep inventories lean relative to sales even though the current rebound in sales for many industries is strong.
They are concerned about the still high
levels of unemployment and are wary of a
sudden softening in demand that could
make inventories excessive once again.
Moreover, the high cost of carrying inventory, due to persistently high interest rates
and lower expected inflation, acts as a substantial incentive to keep a tight control on
inventories. Western firms, in fact, have
made substantial investments in inventory
control over the past ten years.
Firms in the West have reduced their average inventory-to-sales ratios over the last ten
years largely through substantial investments in inventory control. Large retailers as
well as manufacturers and electronics firms
in the West reported that computerized inventory control is the current norm for their
industries, and that high interest rates were
inducing them to continue enhancing their
systems, generally by acquiring more timely
information on inventories and sales.
Expected inflation
Expected increases in the prices of a firm's
products should also affect the cost of carrying inventory and, thus, desired levels of
inventory. The more a business expects its
prices orthe costs of its materials to increase
in the near future, the less incentive it has to
keep inventories low in the present.
This is not to say that inventory rebuilding
and stepped-up production activity are not
occurring in many sectors. In particular,
manufacturers of certain consumer goods as
well as major retailers and electronics firms
are currently enjoying a significant upturn in
sales that is inducing them to rebuild inventories. Energy-related firms likewise expect
to begin rebuilding inventories soon as the
price of oil begins to firm and the winterheating season draws near. Manufacturers
of pulp and paper products are also beginning to rebuild inventories in response to
a strong upturn in sales.
Such a relationship is hard to measure em- .
pirically since one can only observe actual
inflation for the economy as a whole (ex
post) and not expected inflation for each
good. However, evidence from the survey of
firms in the West suggests that, for certain
types of firms, expected price increases are
an important criterion in determining the
level of inventories. In the semi-conductor
industry, for example, prices can change 20
to 30 percent in a fairly short period. An
over-supply of goods in this market can ruin
a firm when prices soften. By the same
token, a firm that correctly anticipates a rise
in prices will have an advantage over other
firms by having increased its inventory
stocks beforehand.
Inventories of heavy equipment manufacturers, in contrast, are still somewhat higher
than desired because this industry has not
experienced the upturn in sales that other
industries have. Lumber inventories are also
currently higher than desired, given the
recent softening in demand due to the decline in the housing industry. Nonetheless,
as firms gain faith in the strength of the
recovery, the prospects for inventory investment and increased production in the West
are likely to improve.
Likewise, retailers indicate that their desired
levels of inventory tend to respond to expectations of future price increases. Given the
widespread expectation that inflation in the
near future will not run close to the double-
Barbara Bennett and Tom Klitgaard
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BANKING DATA ·TWEL.:-rH
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editor'(Gregory:'Tong)
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Reserve'.Bank
ofSan,Frandseo,P.(); Box
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the author •... Freecopiesof
or,:writing the Public InformaFrimdsco 94120. Phone(415)
@FedFRASER