Double Dip Risk Rises After Inventory Blowout: Kevin Hassett
When is quarterly gross domestic product growth of almost 6 percent bad news? When it looks like what was reported last week.
U.S. GDP increased 5.7 percent at the end of last year, with more than half of that growth -- 3.4 percent -- attributable to changes in inventories. This astonishing impact of inventory has ample historical precedent, and the bottom line has terrible implications for 2010.
Inventories are a remarkable corner of the economy. They are the goods and materials that companies keep on hand to make sure that their operations run smoothly. They are the boxes of food on shelves at the grocery store and the bins of metal parts sitting next to the assembly line in a manufacturing plant.
Inventories were a big part of the story during the worst of this recession, and that is nothing new. In a landmark paper published in 1980, Princeton University economist Alan Blinder found that inventories, while accounting for less than 1 percentage point of national output, accounted for 37 percent of the fluctuations in output.
Since Blinder’s paper came out, inventories have held onto their important role. Updating Blinder’s calculations through the fourth quarter of last year, inventories have accounted for about 34 percent of historical fluctuations in GDP since 1947.
Inventories are even more important during recessions. In another paper, co-authored with Louis Maccini in 1991, Blinder found that 87 percent of the decline in GDP from the peak to the trough of the recession was attributable to inventories.
Hard to Predict
Something that constitutes a small share of GDP can have a big impact on its overall volatility only if it is swinging about wildly. Inventories fluctuate so much for a simple reason: Predicting the future is really hard.
A firm tries to set its inventory level to match expected future sales. It must balance the financial cost of carrying inventoried items against the risk that customers might not find the product they are looking for.
In good times, inventories are relatively easy to manage. Demand grows a little bit each quarter, and firms have a good idea what their future sales will be.
Around turning points, expectations can go horribly wrong, and inventories are often the first sign that firms are being surprised by their customers. A car manufacturer might expect that it will sell 100 cars next month and set its production accordingly. If sales fall short, the unsold cars sitting on the lot represent inventory piling up. The manufacturer will likely respond by cutting output, since it already has enough cars on hand to meet next month’s sales.
Peek Into Future
In other words: If we see inventories piling up, firms may need to adjust their future activity downward. On the other hand, sales sometimes jump unexpectedly, driving inventories below their desired levels. When that happens, we can expect firms to ramp up production to replenish their stocks.
Since 1970, there have been nine quarters, like the last one, when GDP grew by at least 3 percent and inventories accounted for at least half of that growth. The history of those quarters is hardly a favorable sign of what is in store.
Inventory spikes make for blowout quarters. In the nine quarters with such spikes, the average growth rate was 6.6 percent and the average inventory contribution was 4.4 percent, even higher than what was observed for last quarter.
Spikes also produce hangovers. The average growth rate in the quarter after a spike was 0.9 percent, a whopping 5.7 percent lower. In the second quarter following a spike, the average growth rate is just 1.6 percent.
More Bad News
To be sure, the inventory story is not the only red flag right now. The unemployment rate in the U.S. is hovering around 10 percent and has shown little sign of recovery. In addition, any positive effects of the economic stimulus are likely dwindling. On top of that, the tax cuts enacted by President George W. Bush are set to expire, and the U.S. deficit is so high that even a subtle swing in interest rates can have major negative budget implications.
Given those factors, we might consider ourselves lucky if we experience only the typical decline in growth that follows an inventory spike. In that case, first-quarter growth in 2010 will be right around zero. If that happens, talk of a double-dip recession will ignite.
Such talk probably should begin now.