The Ups and Downs of Inventory Investment
Real GDP grew at an annualized rate of 3.2 percent in the fourth quarter of 2013, according to the BEA’s advance estimate. Since growth in the third quarter was 4.1 percent, it looks like the US economy finished the year growing at a very healthy pace. Unfortunately the same cannot be said for the early part of 2013, and overall, real GDP growth for 2013 was just 1.9 percent, which is significantly below the 2.8 percent logged in 2012.
The fourth-quarter increase was mainly due to growth in personal consumption expenditures, which, along with net exports, registered their largest contribution to GDP growth since the fourth quarter of 2010. On the negative side, federal government expenditures, which dropped by 1 percent on the quarter, were the main drag on real GDP growth.
Recently, investment in inventories, as measured by a statistic called the change in private inventories (CIPI), has been strong. It accounted for almost 30 percent of GDP growth over the second half of 2013. An oft-overlooked component of GDP, CIPI is extremely volatile and can account for large fractions of changes in real GDP. CIPI is a measure of the value of the change in the real amount of inventories that the private business sector keeps in the course of its production and distribution activities. These inventories might be in the form of finished goods, goods in process, or raw materials and supplies. This variety means they are maintained by all sorts of businesses at different parts of the production chain, be it manufacturers, wholesalers or retailers.
Different forces may affect the inventory levels of different types of businesses. To decide the optimal level of inventory of a particular good, a business will consider the fixed cost of obtaining the good, the cost of storing it, and either the expected utilization rate in production (if it’s an intermediate good) or the future demand (if it’s a final good).
Economists pay attention to total inventories as a proportion of total sales as a way to gauge whether businesses are keeping too much or too little in their inventories. Net additions may mean that businesses expect a stronger future demand, or simply that inventories have been depleted too much and the current level is not optimal. The Bureau of Economic Analysis computes the ratio of the stock of all inventories kept by private businesses to that of total sales, the resulting number being a measure of the number of months it would take to go through the accumulated inventories.
During the most recent recession the inventory-to-sales ratio took a big hit, as businesses slowed production and started going through their inventories at a faster rate than sales decreased. As the recovery started, most of the growth in real GDP was fueled by advances in CIPI. As fast as growth in CIPI has been in the second half of 2013, it was much faster at the start of the recovery. Three quarters into the recovery, CIPI was accounting for nearly 85 percent of GDP growth. Its contribution has since declined and settled at about 20 percent of real GDP growth for the 18-quarter recovery as a whole. This is an extraordinarily high figure given that in the average 18-quarter recovery CIPI has only accounted for roughly 7 percent of GDP growth and it normally constitutes less than 1 percent.
How can a component this small account for so much GDP growth? What is crucial to note is that because GDP is a flow, it is the change in inventories (CIPI) that contributes to GDP, not the stock of inventories itself. Therefore it is the change in CIPI (the change in the change of inventories) that contributes to GDP growth. The following example illustrates how these changes, while small in the context of overall GDP, can be quite volatile and contribute substantially to GDP growth.
Suppose that inventories last quarter dropped by half a percent of last quarter’s GDP, meaning that CIPI was −0.5 percent of GDP, and that this quarter inventories do not change at all, meaning that CIPI is zero this quarter. Also, suppose that overall GDP growth was 1.5 percent from the last to the current quarter. In this purposely simplistic case—but entirely plausible in its magnitudes—CIPI growth is positive and it accounts for a third of the growth in GDP even though the stock of inventories did not change this quarter!
A Simplified Illustration of the Impact of CIPI on GDP Growth
|Other GDP components||100.5||101.5||1.0|
If CIPI is contributing so much above its typical contribution, which GDP categories have not been proportionately contributing as much in this recovery compared to previous ones? While government spending growth was responsible for 10 percent of GDP growth on average in recoveries that lasted at least as long as the current one, it has actually been a drag on growth in the current one.
Note, finally, that these observations are not a statement about whether CIPI, or any other GDP component for that matter, is growing faster or slower in this recovery. We are only commenting on each category’s relative contribution to overall GDP growth, and in that regard CIPI seems to be the most improved.