The latest edition of the Federal Reserve Bank of New York's Current Issues in Economics and Finance, Has Inventory Volatility Returned? A Look at the Current Cycle, is available.
Although the massive liquidation of inventories during the 2001 recession recalls the extreme inventory movements that characterized recessions through the early 1980s, it does not signal a return to the inventory volatility of the past, according to this new Fed study. Authors James Kahn and Margaret McConnell argue that throughout much of the 2001 recession, U.S. firms were successfully controlling their inventories to avoid a sharp buildup of excess stocks.
As the authors explain, the dramatic rundown in stocks in 2001—at an annualized rate of $120 billion in the first three quarters and $114 billion in the fourth quarter alone—followed two decades of moderate inventory movements. In the view of a number of economists, the more stable inventory behavior since 1984 stems from firms’ improved ability to manage their inventories.
To determine whether the 2001 episode was consistent with the recent trend toward better inventory management—or, alternatively, a reversion to the weaker inventory control of the earlier postwar period—Kahn and McConnell compare inventory behavior in 2001 with inventory behavior in the pre-1984 recessions.
The significant differences in the timing of the inventory liquidation that emerge from this comparison suggest that firms in the first three quarters of 2001 were exercising more effective inventory management than they had in the pre-1984 period. While inventory investment remained positive halfway into the pre-1984 recessions, in 2001 it slowed markedly before the start of the downturn and was already negative in the first quarter of the recession. Kahn and McConnell interpret these developments to mean that firms in 2001 anticipated the coming slowdown in sales and began to reduce inventories from the start of the recession in a calculated effort to avoid a heavy accumulation of stocks. By adopting this strategy, the firms were able to avoid the even deeper production cuts that would normally have been required to work off the excess stocks.
In a separate consideration of the record-high fourth-quarter liquidation of inventories, Kahn and McConnell conclude that firms were caught off guard by a strong surge in sales that drained inventories rapidly. Although the consequent shortfall in inventories represented a lapse in firms’ inventory management, the failure to predict sales growth correctly may have been unavoidable given the conditions at the time—the uncertain business outlook created by the events of September 11 and the unusually short duration of the recession.
Finally, the authors examine the implications of the inventory shortfall for economic conditions in 2002. They argue that the shortfall may well contribute to the recovery by prompting businesses to step up production aggressively in order to replenish their stocks. A simulation exercise based on data through the end of 2001 indicates that the increased production could add more than 1 percentage point to GDP growth in 2002. Data for 2002 thus far support this conclusion.
James Kahn is an assistant vice president and Margaret McConnell an economist in the Research and Market Analysis Group of the Federal Reserve Bank of New York.