Declining Inventories Could Help Economy

The nation's shelves are bare. And that could be good news for the economy.

Business inventories have plummeted over the first few months of this year, a major reason that the economy is likely to have shrunk at an extremely fast pace in the first quarter. Analysts believe that the nation's gross domestic product contracted at an annual rate of about 5 percent.

The sooner businesses finish clearing out inventory, however, the sooner they will need to buy goods to keep up with sales. Companies can only draw down what they have in stock so much before having to place new orders, even if sales are weak. A sharp drawdown could set the stage for somewhat better economic conditions -- though probably not a roaring expansion -- in the second half of the year.

Electronics maker Texas Instruments was one of a host of companies this week to announce, as part of its earnings report, that it is nearly done clearing the goods from its shelves. After cutting inventories by $277 million, the company said, its "reductions are essentially complete," and it expects to "moderately increase production levels" in the second quarter.

"Many customers have increased orders as they have begun to slow down their inventory reductions," said Texas Instruments chief executive Rich Templeton. Similar results and prognostications have come from chemicals giant DuPont and chipmaker Broadcom.

That fits with economists' forecasts. During a recession, businesses always race to pare back the volume of goods on their shelves, in warehouses, and in trucks and trains. With lower sales, they want less money tied up in goods just sitting around.

That exaggerates the pain of a recession because while factories are drawing down inventories, they don't need to produce as much, contributing to further job losses and broad economic weakness. Industrial production fell 8.3 percent over the last six months, as the recession deepened.

"There comes a time where the shelves will be completely barren and manufacturers will have to start boosting production and subsequently hiring workers," said Richard Yamarone, chief economist at Argus Research. "You can't keep falling forever."

Predicting when exactly that bottom comes is not easy. The ratio of business inventories to sales has spiked in recent months, as is typical in a recession. In January it stood at a level about equal to its high point of the 2001 recession. But there has been a steep pullback since then, with business inventories falling $18 billion in February alone. Some analysts project that data scheduled to be released Wednesday will show that businesses slashed inventories by $100 billion or more in the first quarter, an amount that would mark one of the steepest reductions ever.

Even when inventories bottom out, companies are unlikely to go on a production boom. Most forecasters expect them only to start cranking out merchandise at levels that make sense given an economy with weak demand from consumers.

There are few signs that consumers are eager to buy more goods given the continued weak job market, dysfunctional financial system, and steep decline in housing and stock market wealth.

"To get real traction in the economy, you need to both have lean inventories and an uptick in demand," said Bruce Kasman, chief economist at J.P. Morgan Chase. "We have the first, but not the second."

One difficulty in analyzing when the turnaround will come is that companies are much better at managing their inventories than they were in the past. Using computer technology, they have a better sense of what they have in stock and where it's located, and they know what sales are up to the minute.

As a result, there have been milder inventory swings in the last two recessions because companies can immediately pull back on production when sales start to drop. But those technological changes also make it hard to know how much companies' demand for goods will snap back once they are done cutting back.