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August 31, 1973 Cautious businessmen, wary of a sales slowdown in the present cycl ical environment, probably are making a thorough check of their stockrooms today to make sure that they are not overloaded with inven tories. For the most part, they need not worry, since buyers have swept the shelves clean in many shops and factories. Altogether, only a modest amount has been added to business inventories during the recent boom period, and inventorysales ratios have fallen to very low levels in the past several quarters. At the same time, some straws in the wind suggest that we are wit nessing the beginning of a buildup in inventories. Between March and June, the overall inventory-sales ratio in manufacturing and trade rose from 1.41 to 1.44. In July, 46 percent of the respondents in the monthly survey of the National As sociation of Purchasing Manage ment reported that they were now adding to their stocks— up from a 39-percent figure in June. Although most businessmen welcome any supplies that they can get, some may be encountering an element of unwanted accumulation, of the type which could eventually generate an inventory correction. Inventories vs. sales Changing trends in inventories can be discerned by analyzing the rela tionship between total inventories and total sales in manufacturing and trade. During the past quarter-cen tury, the ratio has fluctuated cycli cally, between a low of 1.36 in the D ig itize d te -F R ^ S E R period of 1950 to a http://fraser.stlouisfea.org/ Federal Reserve Bank of St. Louis high of 1.64 in the recession year 1970. From that recent peak, how ever, the ratio plummeted to 1.42 by the second quarter of 1973. Over the long-run, rising levels of sales naturally have called for a rising dollar volume of inventory. For example, the $206 billion of inventory needed today to support a $1,267-billion volume of final sales is considerably higher than the $87billion in stocks which supported the $449 billion in final sales a decade and a half ago, despite a sharp decline in the inventory-sales ratio between those two dates. Over time, also, the constant intro duction of new products into the economy plays a part in raising total inventory requirements. Busi nessmen must face the competitive necessity of maintaining a wider range of styles and models of every product, and of having goods avail able to satisfy their customers' wants for speedy delivery and pro duction to order. Nonetheless, these pressures have been offset to some extent over time by several factors which tend to reduce shelfspace requirements. The greatest efficiencies have come from innovations in operations re search and computer techniques, which have increased the efficient movement of goods all the way from the time of raw-material pur chase to the time of final sale. These developments have helped conserve inventories by speeding up stock control and improving the locational efficiency of plants and warehouses. , (continued on page 2) Opinions expressed in this newsletter do not necessarily reflect the views of the management of the Federal Reserve Bank of San Francisco, nor of the Board of Governors of the Federal Reserve System. Aberration in 1960's? In view of the importance of these factors, why hasn't the inventorysales ratio shown a significant downtrend over the past quartercentury? Alternatively, does the sharp increase experienced in the late 1960's simply represent an in terruption in a long-term pattern of decline? There is some tentative evidence to suggest that the answer lies in the latter direction. If so, some explanation must be found for the sudden rise in the inventorysales ratio in 1966 and the mainte nance of that ratio at a high level for a prolonged period. That high ratio was due primarily to a buildup of inventories of defense products, especially aircraft. At all times, inventories are especially important in the durable-goods sector of the economy, since manu facturers in this sector must hold on to large quantities of goods in process because of the prolonged time required for production and the long time-span between order taking and delivery. During the Vietnam buildup, this was especially true for aircraft and other products with long manufacturing lead-times. As a consequence, the ratio of work-in-process inventories to du rable manufacturing sales jumped from 0.76 to 0.94 between 1965 and 1967. This ratio rose further until the 1970 recession, but it has since fallen to 0.86 in the second quarter of 1973, a reflection of weakness in new defense orders and the com pletion of earlier projects. Even so, Digitized t?rvFSA*SEK-sa,es ra ,io re m a in s historically high for the aircraft sec tor, while ratios in practically all other sectors of the economy are now at or below the very low levels reached in 1965. Today's stocks In dollar terms, the net change in stocks has been quite small throughout the current boom pe riod. The picture is muddied, how ever, by the fact that the modest net growth in business inventories has been accompanied by a massive increase in the book value of stocks. In the second quarter of 1973, non-farm inventories rose at a $4.4-billion annual rate, consider ably below the rate maintained throughout the last decade— but book value increased at about a $28.0-billion rate, two to three times as fast as in any other recent year. The explanation is found in the techniques of national-income esti mation, whereby the inventory change is found by subtracting an inventory valuation adjustment (IVA) from the rise in book value. The inventory-change component of GNP is designed to represent the change in the physical volume of inventories, valued at the average price prevailing during each time period. But this is not the same as the change in book value. The latter reflects not only the difference in physical volume, but also the differ ence between the prices of replace ment goods and the prices of goods removed from inventory. This latter adjustment— the IVA adjustment— has been spectacularly large throughout the recent inflationary period. According to incomplete data, it approximated a $23.5-billion annual rate in the April-June period, three times greater than in previous severe inflationary periods, such as 1972 or 1947. The current estimate of a modest inventory buildup thus is the end result of a complex calculation, whereby a very high price adjustment is subtracted from a very high increase in the book valuation of all inventories. Tight supply Assuming this IVA correction is accurate, we are left with the pic ture of a very low level of stocks supporting the ongoing business boom. This conclusion is back stopped by a number of indicators suggesting a tight supply situation. Over the past year and a half, for example, the percentage of firms reporting longer purchase commit ments (60 days and over) for pro duction materials rose from 53 to 78 percent, while the change in du rable-goods backlogs rose from $0.6 billion to $2.8 billion in the same time-span. An interesting development in this situation is the recent difference in behavior of durable- and nondur able-goods stocks. In durable goods, normally the most cyclically volatile sector, a beginning of a buildup is strongly €?vident. Within a year and a half, the change in durable stocks went from a minus $1-billion to a $9-billion annual rate —the highest increase since the 1966 inventory boom. In nondur able goods, where few fluctuations normally occur, a remarkable shift has developed over the same time Ius ^'billion to a Federal R eserve Bank of St. Louis minus $4-billion rate— the first sig nificant decline in decades. Ac cording to these figures, buyers apparently have begun to sweep the shelves clean of food and other nondurables while holding down their purchases of durables some what. Nondurable-goods stocks should return to more normal lev els, however, as the scare buying and other distortions associated with the price freeze are eliminated. Future trends The growth of stocks undoubtedly has been limited by the technolog ical and managerial innovations developed in earlier years for effi cient inventory control— and prob ably also limited recently by the high interest rates charged on funds to finance inventories. Cyclical in fluences must still be heeded, how ever. The level of inventory-sales ratios continues to move inversely with business activity; thus, these ratios should rise if sales decline, and they should remain low if sales continue to rise. Yet, if business should turn slug gish, a severe cutback in inventories need not automatically follow. One reason is the fact that the economy went through an actual recession in 1970 without any inventory reduction—the first time in the business-cycle history of the past generation. More importantly, few if any problems have yet developed at the point where over-stocking generally becomes first visible— that is, at the retail level and at the finished-goods level in durable manufacturing. William Burke uo; 8uiqsPyv\ • q e in • uo 8a.io • epeA0|| • oijepi \ IjB M e H • E jU i O p | B 3 • b u o z jj y . E>JSe|V ^TLBS>TU£q^jnsdte>(Q U pjni© §S>^| BANKING DATA—TWELFTH FEDERAL RESERVE DISTRICT (Dollar amounts in m illions) Selected Assets and Liabilities Large Commercial Banks Loans adjusted and investments * Loans adjusted— total* Com m ercial and industrial Real estate Consum er instalment U.S. Treasury securities Other securities Deposits (less cash items)— total* Demand deposits adjusted U.S. Governm ent deposits Time deposits— total* Savings Other time I.P.C. State and political subdivisions (Large negotiable CD 's) Weekly Averages of Daily Figures Member Bank Reserve Position Excess reserves Borrowings Net free ( + ) / Net borrowed ( - ) Federal Funds— Seven Large Banks Interbank Federal funds transactions Net purchases ( + ) / Net sales ( - ) Transactions: U .S. securities dealers Net loans ( + )/ Net borrowings ( - ) Amount Outstanding 8/15/73 75,561 58,664 20,357 16,967 8,527 5,153 11,744 71,968 21,416 465 48,892 17,599 22,574 5,919 11,711 Change from 8/ 8/ 73 + + + + + + + + + + + - + — + 474 388 38 118 19 12 74 588 99 164 320 93 554 138 425 Change from year ago Dollar Percent + 12,117 + 12,120 + 3,661 + 2,885 + 1,340 767 764 + + 9,614 + 1,941 + 56 '+ 7,557 611 + 6,517 + 739 + 6,072 19.10 26.04 21.93 + 20.49 + 18.64 12.96 + 6.96 + 15.42 9.97 + + 13.69 + 18.28 3.36 + 40.59 + 14.27 -I- 107.68 + + + W eekended 8/15 / 73 W eekended 8 / 8 / 73 Com parable year-ago period 50 226 - 176 20 239 -219 - + 463 + 109 - 1331 + 651 + 267 - - 2 21 23 279 ^Includes items not shown separately. 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