Feature article
The changing role of Inventories in the business cycle
by P. Cross and G. Salvatore*
Changes in inventory levels have been one of the driving forces
of the business cycle, accounting for most of the drop in output
in recessions since World War II. But firms overall have steadily
lowered their inventory-to-sales1
ratio (Figure 1). This paper examines whether better inventory control
has been one reason behind the steadier growth of the economy over
the past decade. It also looks at the reduction in the economy-wide
ratio of inventories to sales and which sectors have or, just as
interestingly, have not participated in this decline.
Figure 1
All the sectoral data used in this study come from the Income and
Expenditure Accounts and are in nominal dollars (with the focus
on the ratio of stocks to sales, deflating both by prices to convert
to constant dollars makes no difference). Inventory data are available
for manufacturing, wholesale and retail trade, as well as ‘other’
non-farm industries (which include mining and utilities).2
Data for individual industries come from the monthly surveys of
manufacturing and wholesale trade,3 but these
are only available back to 1992.
The volatility of GDP
Table 1 shows the variability of quarterly real GDP growth over
the last four decades (the end points of 1970, 1982 and 1991 were
selected so that each decade includes a full business-cycle expansion
and contraction). The results show that the standard deviation (a
measure of variability) of GDP growth was little changed at about
1.0 up to 1991, except for a brief increase during the economic
upheaval of the 1970s that culminated in the 1981-82 recession.
During the 1960s and 1970s, the variability of GDP excluding inventories
was slightly less than overall GDP, implying that inventory changes
were aggravating the instability of the economy. This is consistent
with the results of researchers in the US who, unexpectedly, found
that output was more variable than sales and that stocks did not
act as a buffer against unexpected fluctuations in demand (Blinder
and Maccini, p. 74).
Table 1: The variability* of Real GDP and Final Sales Growth
|
GDP |
GDP ex non-farm inventories |
|
|
|
1961-1970 |
0.897 |
0.838 |
1971-1982 |
1.065 |
1.012 |
1983-1991 |
0.888 |
0.956 |
1992-2003 |
0.519 |
0.615 |
* As measured by standard deviation |
|
This began to change in the 1983-1991 cycle, when the variability
of GDP was 7% less than GDP excluding inventories. This coincided
with the introduction of just-in-time inventory systems pioneered
in Japan (notably in the auto industry) and the initial diffusion
of computer technology to aid the monitoring of inventories. As
well, the federal government in 1986 abolished a 3% tax break for
inventories (Phillips, p. 43).
Figure 2
By plotting the standard deviation of real GDP for successive 20-quarter
intervals over the last four decades, Figure 2 shows how the variability
of growth has fallen.4 The last decade has
seen a marked drop in the volatility of output. The standard deviation
of GDP growth fell 46% from the 1980s to just 0.52, half its average
of the previous three decades. Reasons for this drop are numerous,
including smaller fluctuations in inflation and interest rates as
well as fewer shocks to supply; the most notable manifestation was
the absence of a recession during this period. But better inventory
control also played an important role: the standard deviation of
GDP was 19% lower than GDP excluding inventories, on top of the
initial gap of 7% that had opened up in the 1980s. (We do not attempt
to disentangle whether better inventory control was the cause of
more stable output or the result of smoother sales).
Figure 3 confirms that the relationship of final sales and inventories
has changed in a manner that dampens the business cycle. From 1982
to 1991, changes in demand and inventories reinforced each other,
with an overall correlation of 0.77. Small dips in demand in 1982
and 1991 triggered large cuts to stocks. Without any initial build-up
when sales first slumped, the drop in inventories suggests firms
anticipated a prolonged period of weak demand. From 1992 to 2003,
however, the correlation dropped to 0.37, with stocks moving in
the opposite direction when sales suddenly changed course in 1995,
1996, 1999 and 2002. Inventories therefore acted more as a buffer
shielding output against fluctuations in demand, helping to smooth
out the business cycle. This may reflect the increasing confidence
that firms have that, if sales jump unexpectedly, they can quickly
replenish stocks (Filardo, p.30). As well, hoarding raw materials
as a hedge against commodity shortages, as occurred in 1974 and
1980, has greatly diminished.5
Figure 3
In the next section we look at how diffuse the trend to lower inventories
has been by examining the ratio of inventories to sales in the major
non-farm sectors and the most important industries within each.
Who holds inventories?
Of the $180 billion of inventories in Canada in mid-2003, the largest
part (38%) was held by manufacturers (Table 2). Of this, 40% were
raw materials used to make goods; 33% finished goods; and the remainder
goods at various stages of production (goods-in-process) or goods
purchased for resale. By industry, transportation equipment alone
accounted for one-fifth of all stocks in manufacturing (mostly in
aerospace and railway cars, which held three times as much stock
as the auto industry). The chemicals and computer and electronic
product industries each held about 10% of all manufacturing stocks.
Other notable holdings were in food, wood, primary metals and machinery.
Table 2: Inventories by sector*
|
Level |
Percent of total |
|
(Billion$) |
|
|
|
|
Total non-farm |
180.2 |
100.0 |
|
|
|
Manufacturing |
69.2 |
38.4 |
Raw materials
|
27.7 |
15.4 |
Goods-in-process
|
14.1 |
7.8 |
Finished goods
|
22.5 |
12.5 |
Goods purchased for resale
|
4.8 |
2.7 |
Wholesale |
49.4 |
27.4 |
Retail |
47.0 |
26.1 |
Motor Vehicle
|
15.9 |
8.8 |
Other |
14.6 |
8.1 |
* Data for second quarter, 2003 |
|
Outside manufacturing, wholesale and retail trade had just over
26% of all non-farm inventories.6 The motor
vehicle industry alone accounted for nearly one-quarter of these
stocks.
All three sectors began the 1990s with inventory-to-sale ratios
of about 0.6 (Figure 4). This obviously included some stocks accumulated
involuntarily by firms when sales slumped in the recession, since
each sector quickly reduced its inventory ratio when demand recovered
early in the decade. Thereafter, each followed its own course. Wholesalers
slashed stocks steadily, while retailers consistently had the highest
inventory ratio over the past decade. Manufacturers struggled to
rein in inventories during their recent slump in demand, and saw
the largest increase in the ratio of stocks to sales compared with
the mid-1990s. Historically low interest rates since then also may
have reduced the incentive to trim stocks further.
Figure 4
Manufacturing
Manufacturers have shown several distinct trends in their inventory
control. From the end of the recession in 1991 to 1995 they made
steady reductions, as more industries adopted new technologies and
inventory management practices during the recovery. However, after
1995 the trend turned up, accentuated by the slack in sales after
2000. Since 1998, only 5 of 21 industries were able to further rein
in their stocks. In fact, several industries had sharply higher
inventories for several years, notably aerospace and computers and
electronics, partly due to an extended slump in demand. This highlights
how easily the forces of the business cycle can overwhelm technical
and managerial advances. In fact, the upward pressure on inventories
in recent quarters left only a minority (10 out of 21) of industries
with inventory ratios lower than 10 years ago.
Several factors combined to produce this surprising increase in
inventories in recent years. But a rising inventory ratio does not
always mean flagging sales or poor cost control. The sharpest increase
in stocks has been for goods in process, which reflects the success
of aerospace and railroad equipment firms in booking new orders.
These industries require long periods of on-site construction within
the firm.
Figure 5
Inventories of raw materials fell slowly relative to shipments until
1995, but then began to creep up. For raw materials, this may reflect
the exhaustion of gains to be made from new controls such as just-in-time.
The auto industry has seen little change in its overall ratio of
stocks to sales in the last decade, after its pioneering adoption
of the just-in-time delivery of inputs in the 1980s. As a result,
its ratio of raw materials inventories to shipments has been steady
at less than 0.1—still by far the lowest of any industry.
However, some industries saw raw materials inventories rise over
time. In particular, the stock ratio for computers and electronic
products nearly doubled in recent years (the collapse of sales in
this area led to only a small uptick in stocks of finished products).
As well, the chemical industry saw its raw materials inventory ratio
nearly double in the last decade.
Finished goods also fell behind shipments until 1995, driven by
the recovery from recession. But they rose sharply during slowdowns
in demand in 1997 and 2001. The nosedive in aircraft sales after
September 11 doubled the stock-to-sales ratio for aerospace manufacturers,
while computer and electronics also edged up.
Figure 6
It is ironic that the computer and electronics industry saw the
largest increase in its overall inventory-to-sales ratio, since
it was the technology embedded in its products that is credited
with helping to better control inventories in other industries.
But some areas of this industry appear to have struggled to apply
these principles to itself. While its inventory-to-shipments ratio
was steady for most of the 1990s, the surge of demand related to
the Internet and the Y2K bug coincided with an increase in the ratio
to nearly 0.7 late in 1999, perhaps as the riches garnered by this
industry reduced the importance attached to strict cost controls.
The subsequent sales slump helped send inventories to above the
level of sales, and the industry has struggled to reduce the ratio
ever since. It is not clear why falling sales led to a sharper increase
in stocks of raw materials than finished goods: while the initial
increase in stocks in 1999 accompanied booming demand and may have
reflected a build-up in anticipation of higher output, this has
long since ceased to be a factor.
Figure 7
Goods purchased for resale reflect the wholesale activities of
manufacturers. For example, if a manufacturing firm decides to specialize
in producing one product line in Canada and import others, these
imports would be classified as goods purchased for resale.7
The share of these goods in inventories has been little charged
in recent years.
Wholesale
Wholesalers made the largest reductions in their stocks relative
to sales of any sector in the economy, with a drop of nearly one-third
over the last decade. Moreover, it is the only sector to have sustained
its decrease throughout, leaving the ratio at 0.4, the lowest of
any sector.
Even here, however, the drop in inventories was confined to a small
number of industries. Figure 8 shows that the reduction in the inventory-to-sales
ratios in motor vehicles and computers (including software) accounted
for most of the decline. The fast growth of these two industries,
especially computers in the late 1990s, also reinforced the overall
drop for wholesalers, since they had inventory ratios below the
wholesale average. A majority (4 of 7) of wholesale industries posted
no significant decrease in their inventory ratios, while they showed
the least volatility of any sector other than non-auto retail.
Figure 8
Retail
The recent levelling-off of the inventory ratio for retailers masks
divergent trends. Auto retailers reduced their ratio of stocks to
sales from over 0.9 in the early 1990s to as low as 0.55 in the
sales boom when 0% financing was first introduced in the wake of
the September 11 attacks, before rising to 0.7 when sales slowed
in 2003. While trending down, auto retailers have among the most
volatile inventory ratios of any industry, a reflection of the capriciousness
of demand.
Figure 9
Excluding auto dealers, however, reveals little change in inventories
in the rest of the retail industry, with a ratio hovering around
0.55 for most of the last 15 years. The absence of cuts in non-auto
stocks is surprising given the proliferation of scanning and barcode
technology. This may reflect the need for retailers to always have
sufficient stock on hand (to avoid ‘stockouts’) in view
of the impulsive nature of some consumer spending. Others speculate
that rapid growth in retail capacity as new firms entered the market
raised inventories, especially the trend to large stores that offer
a wider selection of products (Lau, p.42). As well, the low level
of stocks held by suppliers in manufacturing and wholesaling may
have forced retailers to hold buffer stocks themselves.8
Still, the stability of their inventories (their ratio has the lowest
standard deviation of any sector since 1988) also suggests that
non-auto retailers have increased their technical ability to control
stocks.
Conclusion
Firms have profited from their aggressive reduction of inventories
relative to sales over the last two decades, particularly after
the recession in the early 1990s. If the ratio of non-farm inventories
to sales were the same today as in 1974, firms would be financing
an extra $229 billion in stocks, plus the extra storage space required.
At the current prime rate of 4.5%, this represents a savings of
$10.3 billion, freeing these resources for other uses.
But the overall economy has also benefited from better inventory
control. It is probably too soon to pass judgment on the claim that
“the history of inventory-induced recessions has probably
come to an end,”9 but fluctuations
in GDP are less pronounced than in earlier decades and the absence
of over-built inventory levels has contributed to our avoiding outright
recession in the past decade.10
Nevertheless, the inventory-to-sales ratio has not dropped in all
sectors of the economy. Wholesalers have led the way, driven by
autos and computers. Manufacturers pioneered some of the techniques
to reduce stocks, but recently have been unable to stop a build-up,
notably in computers and electronics. Meanwhile, retailers have
not reduced their inventory-to-sales ratio at all, especially outside
autos, leaving the door open to more reductions in the future.
Bibliography
Blanchard, O. and J. Simon; “The Long and Large Decline in
U.S. Output Volatility.” Brookings Papers on Economic Activity,
1: 2001.
Blinder, A. and L. Maccini; “Taking Stock: A Critical Assessment
of Recent Research on Inventories.” Journal of Economic Perspectives,
Vol. 5, No.1, Winter 1991.
Filardo, A.; “Recent Evidence on the Muted Inventory Cycle.”
Federal Reserve Bank of Kansas City Economic Review, Second Quarter
1995.
Lau, H.-H.; “The Role of Inventory Management in Canadian
Economic Fluctuations.” Bank of Canada Review, Spring 1996.
McDonough, W.; “Remarks Before the NY State Bankers Association
Annual Financial Services Forum.” Federal Reserve Bank of
New York, March 20, 2003.
Phillips, P.; “Inventories and the Business Cycle: Policy
Implications.” Policy Options, April 1994.
Ramey, V. and K. West; “Inventories.” NBER Working
Paper No. 6315, Dec. 1997.
Notes
* For more information on inventory data and concepts, contact
G. Salvatore, Income and Expenditure Accounts (613) 951-3795.
1 Final sales of goods are defined as personal
expenditure on goods, government current expenditure on goods, all
fixed investment except transfer costs, and goods exports. Imports
are not removed since it is unknown how much are in inventory or in
final sales.
2 Since other industries account for less than 10% of inventories,
they are excluded from the sectoral analysis.
3 There are small conceptual differences between the two
sources of inventory data, mostly related to the inclusion of goods purchased
for resale in the Accounts. To make quarterly and monthly stock-to-sales
ratios comparable, monthly inventories are divided by three.
4 The methodology is derived from a study of price and output instability
by Blanchard and Simon (2001). McDonough (2003) uses similar techniques.
5 Changes in the variability of the economy-wide ratio of inventories
to sales confirms this trend. From 1974 (when data begin) to 1991,
its standard deviation was 0.21. Since then, that has fallen to just
0.05.
6 This is very close to the distribution of non-farm stocks in the
US : manufacturing 37%, wholesale 26%, retail 26% and other 11%
(Ramey and West, p. 74, Table 4).
7 In fact, the drop in the GPRS ratio in 1993 reflects the reclassification of
the wholesale activities of auto firms from manufacturing.
8 Interestingly, data for department stores showed a downward trend
from 1999 until the series was terminated in October 2002, although
the ratio was still very high at nearly 3.0.
9 G. Epstein “Looking for Proof in All the Wrong Places: Economists
Miss the Point on PCs and Output”, Barron’s, May 25,
1998. See also “The ratio that lost its relevance” by
J. Kettle, Globe and Mail, Feb. 19, 1998.
10 At least one researcher speculated that one corollary of better
inventory control in recessions is slower output growth during recoveries,
as occurred in Canada in 1992 and in the US in 1992 and 2002. See
M. McConnell and G. Perey-Quiros, “Output Fluctuations in
the United States: What Has Changed Since the Early 1980’s?”
The American Economic Review, Vol.90, No.5 (Dec.2000), p. 1475.
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