Inventory-driven U.S. recovery may be delayed
Steady improvement in manufacturing surveys, payroll data and freight movements all indicate the U.S. economy is approaching the low point in the business cycle and should hit the bottom within the next one to four months. But that does not necessarily imply a strong and sustained expansion is about to get underway.
It is possible to be optimistic that the worst of the downturn is now over (or nearly so), while remaining cautious about prospects for strong and sustained recovery once the cyclical turning point is passed.
The slow and fitful recovery from the last recession is one reason to be careful. The National Bureau of Economic Research (NBER), the traditional arbiter of the U.S. business cycle, dates the last trough to November 2001 (eight months after the expansion peaked in March 2001 and just two months after the attack on the World Trade Centre). But signs of a strong and sustained recovery did not emerge for more than two years.
Fitful expansion in 2002 and 2003 is one reason the Fed kept interest rates so low for so long. While many commentators now see this is a significant error that contributed to subsequent bubbles in the bond and real estate markets, at the time the slow recovery caused officials, led by then-Governor Ben Bernanke, to worry more about the risk of deflation taking hold.
The Fed was still cutting interest rates to 1.00 percent as late as June 2003, an insurance policy against falling prices. It did not feel emboldened to begin raising them from this ultra-low level until June 2004.
Uncertainty caused by impending war between the United States and Iraq was certainly one factor overshadowing the recovery, but not the only one. Widespread pessimism and a cautious approach to new investment and hiring all helped ensure recovery was very slow. It failed to become clearly self-sustaining for almost three years.
The same could easily happen again.
RESTOCKING AND FINAL DEMAND
Headline increases in gross domestic product (GDP) can be separated into growth from final demand (consumption, business investment, government spending and exports); and increases in the level of inventories held by manufacturers, distributors and retailers along the supply chain (including raw materials, work in progress and stocks of finished but unsold items).
Sustainable increases come from final demand. Inventories are more volatile. Large changes in either direction tend to be quickly reversed within a quarter or two. A large build up in one quarter is usually followed by an equally large reduction in the following one.
The attached chartbook shows quarterly growth rates for GDP, final sales and inventories since 1948, and how the U.S. economy behaved in the first four quarters after each recession ended. Click here for PDF.
Headline GDP and final sales have proved much more stable than inventories. GDP and final sales have been negative in 37 and 35 quarters respectively out of a total of 245 since 1948. In contrast, inventory changes subtracted from GDP about half the time (119 quarters) and added to it roughly as often (126 quarters).
Recessions since 1948 can be divided into two very distinct groups:
(1) Severe recessions characterised by declines in final demand for at least two consecutive quarters. There have been four of these severe recessions (ending in 1954, 1974, 1982 and 1991).
(2) Other, inventory-driven recessions where final demand remained positive (most of the time) but the attempt to liquidate excess inventories by cutting production below final consumption pushed the economy into recession (defined as two quarters of negative overall GDP growth). There have been five of these “other recessions” or “inventory recessions” (ending in 1949, 1958, 1960, 1970 and 2001).
Past experience suggests the early stages of recovery are very different depending on whether the economy is emerging from a severe recession or an inventory-driven one.
In the case of deep recessions, recovery has been led by final demand. Inventory changes continued to subtract from GDP growth in the first quarter after recession ended and did not begin to make a substantial positive contribution until the third quarter (six to nine months later).
The pattern after inventory-driven recessions has been very different. Growth in final demand was much less important, with inventory rebuilding supplying most of the initial impetus for expansion.
In four of the five inventory recessions since 1948 inventories made a positive contribution to GDP from the first quarter after the downturn ended. The exception was the anaemic recovery after the 2001 recession. The lack of a stronger inventory response in this instance may have contributed to the failure to achieve a self-sustaining recovery in this case. But in every case, the inventory-driven recovery fell away somewhat in the second quarter after the recession ended before surging again in the fourth.
From the charts, it is clear that the current downturn looks much more like a severe recession than an inventory de-stocking one (with sharp falls in final demand in both Q4 2008 and Q1 2009).
If this is the correct characterisation, inventory rebuilding may play only a limited role in the early months of the recovery. Assuming the cyclical trough occurs during Q3 (between July and September) re-stocking might not make a significant positive contribution to growth until Q1 or even Q2 2010.
Analysts hoping for inventory rebuilding to provide much of the impetus for recovery in the second half of 2009 may be disappointed. Any expansion in the final months of 2009 is likely to be much slower and more uncertain.