Late last summer as signs of recession became unmistakable, the economic forecasters had at least one comforting thought: unlike in the early 1970s, business inventories had not ballooned to precarious and unsustainable levels during the 1980-81 upturn. The coming recession was therefore unlikely to be magnified by a massive liquidation of unwanted inventories, they said.
Unfortunately, the first quarter of this year saw a record decline in the level of inventories, which in turn dragged down the Gross National Product--the broadest measure of how much the economy produces. Apparently, business inventories were not as lean as they looked before the economy began to slide.
Some economists believe that in coming months businessmen may be as reluctant to build up new inventories as they were to hold on to their existing stocks earlier this year. Instead of a sharp swing in the stock cycle, which would help to get the economy moving again, there is a risk that firms will choose to keep their inventories unusually low.
"I don't think inventories will be enough to pull you out of it the recession ," comments economist George Perry of Brookings Institution.
Administration officials hope that consumer spending will pull the economy up. In one sense, the chances of a quick upturn in production are stronger the lower the level of business inventories when sales begin to improve. Business is more likely to respond to an increase in sales by raising its output if it does not already have a high level of stocks.
Yesterday's report of a drop in manufacturing and trade inventories can be interpreted in that light as a helpful sign. A strong rise in retail sales in May helped to push inventories down, and to lower the ratio of stocks on the shelves to sales.
However, the economy "will probably have to have several months of rising sales before" a recovery in production really gets under way, according to Allen Sinai of Data Resources Inc. He believes that a combination of high interest rates, and technical changes that make it easier for businesses to manage with a lower ratio of stocks to sales, will deter firms from building up their inventories until they are really convinced of a sustained recovery in sales.
It would be surprising if that were to happen yet. A government report earlier this week showed that May's buoyant sales figure was followed by a further decline in retail trade in June. Several forecasters who were encouraged by May economic indicators to believe that the recession had bottomed out, have become more pessimistic about the prospects for recovery as poor data for June have been released. It is "still hard to find any clear evidence that the trough has been passed," according to Rudolph Penner of the American Enterprise Institute, who describes himself as usually an optimist.
High interest rates, particularly when coupled with slower inflation, have made it extraordinarily expensive for business to hold inventories in the past year. With the cost of carrying inventories approaching 20 percent, firms have to anticipate large price increases to make it worthwhile holding on to more than the bare minimum of stocks. If sales weaken at all, companies are likely to respond by liquidating more stocks.
Most forecasters expect interest rates to remain high in coming months, particularly relative to the rate of inflation. This will keep business cautious about carrying inventories. "I don't really believe that business has done all the destocking" that it will, Sinai said.
Continued inventory liquidation in the April to June period need not imply a drag on GNP because it is the changes in inventory levels, rather than the levels themselves, that affect GNP.
When inventories drop, the economy is producing less than is being consumed, or business is "disinvesting." The stocks decline is subtracted from the GNP total to reflect that. If there is then a switch from a large decline in inventories to a smaller decline, this has a positive impact on GNP: the "disinvestment" is smaller. Indeed, current predictions of a flat or slightly rising GNP in the second quarter of this year are based on the assumption that even if stocks did continue to decline in the April-to-June period, the drop would have been considerably smaller than that recorded in the first quarter, so the impact on GNP would be positive.
Changes in business stocks have a big impact on the GNP numbers but they are notoriously hard to measure and can sometimes obscure underlying trends in the economy. Business inventories may rise involuntarily because sales are lower than expected, or they may be built up deliberately in anticipation of higher sales in the future. In both cases the build-up will tend to boost GNP, although in one case it is likely to be followed by a decline in production to match lower sales and in the other case it is not.
What seems unlikely now is that a glimmer of recovery will be sufficient to entice business to increase stocks and thus magnify the rise in output. "I don't expect the typical inventory rebuilding over the next four to five months" that generally comes with recovery, said Larry Chimerine of Chase Econometrics. Another economist warned that if sales in the second quarter turn out to have been lower than at the end of last year, business could go on running down inventories through the second half of this year.