Insight Line—June 25, 2007

Economists have long used inventory investment as a harbinger of future economic activity. If total inventories were too low, economists’ forecasts focused on economic growth driven by inventory restocking. Conversely, if inventories were too high, concerns about an economic slowdown dominated the forecasts. However, as the following chart attests¹, someone forgot to explain the cause and effect to those responsible for inventory management because they seem to have a one-track mind—less is better.

Over the past 25 years, all walks of inventory managers, from manufacturing to wholesalers to retailers, instituted technologically advanced logistical practices with one purpose in mind: reduce inventory volatility. And, judging from the available data, they’ve been phenomenally successful, as all widely followed inventory-to-sales metrics are but a fraction of what they once were. In other words, corporate America is essentially operating “just-in-time” production schedules (that is, limiting production to small lots or the amount needed by customers in a single day, for example,) rather than stocking a large quantity in advance “just-in-case”. This change has some important implications not only for the economy’s growth prospects for the remainder of 2007 but also for broader economic theory.

Current prevailing wisdom amongst economic prognosticators is for an inventory-driven rebound in gross domestic product (GDP) growth in the coming quarters of 2007. Anecdotal support from regional manufacturing surveys such as those produced by the Chicago, New York and Philadelphia branch banks of the Federal Reserve System suggests such forecasts may be on the right track.

However, if history is any guide, inventory swings are temporary at best and are growing ever rarer. It wasn’t that long ago that researchers at the Federal Reserve Bank of New York (McCarthy and Zakrajsek, 2003, updated 2007)² concluded that structural changes in the macroeconomic landscape—the move to just-in-time inventory management and the advent of globalization—now play a decisive role in the reduction of quarter-over-quarter volatility in the nation’s annualized real rate of GDP growth. Simply put, inventories are not as important to swings in GDP as they once were.

Yet such change does not happen in a vacuum. Arguably, the pace of advance to inventory management benefited greatly from the Federal Reserve’s adherence toward emphasizing policy fostering price stability.

Writing in August 2003, Nobel Laureate Milton Friedman suggested Federal Reserve policies designed to foster price stability have beneficial inflationary implications for the economy as a whole.³

And one of them, I believe, is inventory management. You see, in a stable macroeconomic price environment, inventory managers can focus on fulfilling production for final demand, rather than managing price changes on work in progress.

Whatever the case—management practice, monetary policy or a combination—the larger implication, as I see it, is that another economic tenet from years gone by is losing some of its luster.

¹ Selected Inventory to Sales ratios from 1/31/1982- 04/30/2007, Ned Davis Research, Inc., © 2007

² McCarthy, Jonathan and Zakrajsek, Egon, “Inventory Dynamics and Business Cycles: What has Changed?” Working Paper 2003-26, Federal Reserve Bank of New York, June 2003. An updated version appears in the Journal of Money, Credit and Banking, Volume 39, Issue 2- 3, March-April 2007.

³ Friedman, Milton, “The Fed’s Thermostat,” The Wall Street Journal, August 19, 2003.

This material has been prepared using sources of information generally believed to be reliable. No representation can be made as to its accuracy. The forecasts and opinions in this piece are not necessarily those of Van Kampen, and may not actually come to pass. Information in this report does not pertain to any Van Kampen product and is not a solicitation for any product.