Inventories have an important role in defining the business cycle and exert significant influence on perceptions of prosperity as measured by the national income accounts. As Chairman Bernanke noted in his recent testimony before Congress, inventories will be an important part of the near-term outlook for the U.S. economy.1 In the first quarter inventories fell by $103.7B, which subtracted 2.79 percentage points from real gross domestic product (GDP), almost half of the overall decline (Figure 1). Stockpiles have fallen by nearly $230B since the start of the recession-more than for any prior recession. The inventory decline remains significant even when looked at as a percentage of GDP (Figure 2). Over our forecast horizon we expect this decline in inventories to be the largest in the post-war era, in dollars as well as a percentage of GDP. While inventory levels will continue to contract, we estimate that in the second half of the year inventories will begin to add to GDP. The rebalancing of inventories and final sales defines the dynamics of the business cycle. Despite all the focus on the collapse of recently created financial instruments, the outline of the economic cycle follows the drive of inventories.

Relevance of Inventories to the Business Cycle

In the context of the business cycle, inventory investment is a small but highly volatile component of aggregate demand. Inventories can often cause unpredictable swings in GDP. To be clear, the measure of inventories that enters into the national income accounts is not the change in the value of inventories, but rather it is the change in the change that determines the effect on GDP.2 Because of the enormity of the first quarter inventory drawdown, the second quarter inventory decline will have to be massive in order to have a negative impact on GDP. We believe that stocks will continue to shrink, and that production shutdowns at GM and Chrysler will turn the second quarter into the largest inventory decline of the cycle. By the second half of this year, the pace will be slower and thus inventories will become additive to GDP.

Inventory investment is tied closely to the business cycle, and often reinforces it. We can see this over many cycles (Figure 2). For example, inventories added to growth following the recessions in the early 1980s and 1990s, and deepened the recessions of 1991 and 2001. As weakness begins to appear in the economy, sales start to slow, and inventories begin to accumulate on firms' shelves beyond the anticipated and intended amount. This imbalance of unintended inventory accumulation provides an important dynamic to the business cycle. Previously placed orders and planned production continue for some time as firms are unsure if the decline in sales is permanent or merely an anomaly. Therefore, inventories continue to rise as sales fall further. The rise in the inventories/sales ratios suggests an imbalance in the economy.

Firms begin to intentionally reduce inventory investment to align with demand by limiting new orders and slowing or stopping production, depending on their place in the supply chain. Of course, the effort to pare inventories adds more weakness to the economy in the short run by further reducing aggregate demand. This can be a lengthy process because of the sluggish adjustment in production. Moreover weaker-than-expected sales may put a floor under inventories. Sales must exceed output in order to reduce inventories even when both sales and inventories are declining. A significant inventory reduction is a prerequisite for any substantial pick up in industrial production, and inventory reduction is difficult to achieve without a pick up in consumption to spur sales and shipments.

This internal economic cycle dynamic is reflected in inventories/sales ratios which have reached extreme highs during this cycle (Figure 3). Firms try to balance their inventories precisely in order to manage costs; they do not want to tie up excess cash in stockpiles because the true cost of inventories includes the cost of goods plus the opportunity cost of foregoing alternative uses of the funds. Technological advances, e.g. just in time inventories, have created efficiencies in inventory management that were previously impossible. Such innovations have contributed to a long period of decline in relative levels of inventories, but have not eliminated all volatility.

The longstanding improvement in inventory ratios seen from 1992 to 2006 has been severely reversed over the course of the current recession. Sales dried up rapidly and unexpectedly, leaving merchants unable to move product, and inventories skyrocketed. This enormous unintended inventory investment occurred due to the sudden and severe nature of the current economic decline. Because sales were plummeting faster than suppliers could pare inventories, inventory ratios climbed to levels not seen since the 1990s (Figure 3). During the third quarter and the fourth quarter inventories fell, but only reluctantly. The correction finally gained strength in the first quarter of this year (Figure 4). Only recently have any signs of progress shown up in these ratios, and sustained improvement will depend on sales strengthening and also on limited production. Once merchants are comfortable with their level of stocks and are feeling more positive about the near-term economic outlook, production will be called on-line once more. The timeline for this is uncertain, and we do not expect industrial production to increase until the fourth quarter of this year. Demand from firms will enhance and support the eventual economic recovery, and the recovery will be somewhat stalled until then.

Contextualization of the Current Inventory Cycle

The turmoil in the auto sector provides a real time example of this phenomenon-Chrysler and GM are currently closing factories. This production halt will allow the vast surplus of auto inventories to begin to fall and find a new equilibrium, though not without additional economic fallout as more jobs are lost (Figure 4). More than a year from the start of the recession, it is clear there is a significant lag between the time slack in the economy is recognized and when firms are finally able to clear meaningful levels of inventory in an environment of falling sales. Historically the largest decreases in inventory have occurred near the end of or after recessions, once production is slowed or stopped (Figure 2). The positive consequence of inventory reduction relies on the expectation that eventually sales will pick up and businesses will once again aim to add to their stockpiles. Bulking up production will provide jobs and spur economic growth. While this moment will not likely occur in the near term, it remains an integral part of our long-term outlook for economic growth.

The present inventory drawdown is already at historic levels (Figure 5). By the end of 2009, we expect it will be the greatest in the post-war period. Other notable inventory cycles occurred in the 1948-49 recession as well as the 1981-82 recession. Researchers have wondered whether the technological advancements in inventory management since the 1980s have reduced the effects of the inventory cycle. The 1990-91 inventory liquidation was not as severe, and the 2001 recession may owe the large drawdown in part to an unexpected jump in sales following the September 11 terrorist attacks. During the current recession, despite improved inventory management systems, firms were surprised, like most economic forecasters were, by the sharp decline in activity accelerated by the collapse of Lehman Brothers and the freezing of the financial system. This cycle has demonstrated that inventory changes can still exert significant influence on the economic cycle and GDP. We will continue to closely monitor inventories and sales as the business cycle progresses.