Academic journal article Economic Review - Federal Reserve Bank of Kansas City

Recent Evidence on the Muted Inventory Cycle

Academic journal article Economic Review - Federal Reserve Bank of Kansas City

Recent Evidence on the Muted Inventory Cycle

Article excerpt

Inventories play an important role in business cycles. Inventory build-ups add momentum to the economy during expansions, while inventory liquidations sap economic strength during recessions. In addition, because inventory fluctuations are notoriously difficult to predict, they present considerable uncertainty in assessing the economic outlook.

The role of inventories in shaping the current outlook for the U.S. economy is particularly uncertain. In the early 1990s, inventory swings appeared less pronounced than usual, leading some analysts to conclude the business cycle might now be more muted. New inventory control practices, they believed, were permanently diminishing the role of inventories in the business cycle. Yet, recent strong inventory restocking suggests this conclusion might be premature. Inventories may be just as important in the business cycle today as in the past.

This article examines recent inventory data to assess whether the role of inventories in the business cycle has changed. The first section reviews the argument that new inventory control practices have muted swings in inventories. The second section uses data from the current expansion to update estimates of the empirical relationship between inventories and the business cycle. The article finds little evidence to suggest inventories are playing a reduced role in the business cycle, and therefore rejects the view that a change in inventory behavior has muted the business cycle.

IMPROVED INVENTORY CONTROL AND THE MUTED INVENTORY CYCLE

During the last two decades, many firms have successfUlly adopted new inventory control practices. By modifying the way they manage their inventories, firms have lowered costs and strengthened their balance sheets. The widespread adjustments made at the firm level have raised the possibility that inventory behavior throughout the economy has also changed, thereby altering the business cycle.(1)

Tighter control produces leaner inventories

Many businesses have been able to reduce costs by holding leaner inventories. The cost savings arise from tighter control of the flow of inputs into the production line. Tighter control enables firms to produce without disruption because the firm receives smaller but more frequent supply deliveries. Such a practice helps firms reduce their level of inventories for any level of production.(2)

To understand how more frequent deliveries of supplies can reduce inventory levels, imagine an auto assembly line designed to produce 200 cars each month. Under the old inventory system, the carmaker might receive a delivery of 200 chassis on the first of each month. At the end of the first production week, the accountant's ledger would show 50 cars produced and 150 chassis remaining in the stockroom as inventory. At the end of the second week, the ledger would show 50 cars and 100 chassis, and so on. Thus, at the end of the month, the accountant's ledger would show the plant had produced 200 cars, with a weekly average of 100 chassis in inventory.

Under a more tightly controlled inventory system, the carmaker could reduce stockroom supplies by receiving chassis deliveries on a more timely basis. For example, if delivered weekly, the chassis inventory would begin each week at 50. Working the inventory down to zero during the week, the firm would reduce its weekly average inventory holdings to 25. Thus, the new inventory control practices would help the carmaker cut its weekly average level of inventories from 100 to 25 chassis.

By fostering leaner inventories, the new inventory control practices produce both direct and indirect benefits to the firm. Direct benefits stem from lower costs of production. For example, a firm can cut interest costs because it can finance leaner inventories, and the firm may cut rental costs by requiring less warehouse space. Indirect benefits arise from the production flexibility that is inherent in the new practices. …

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