I continue to believe that the U.S. economy is already in or about to enter a recession. And excess inventories are the key to recessions, despite the widespread feeling that stocks of goods are currently under control. In postwar recessions, inventory corrections accounted for an average 79% of the decline in real gross national product.
Over-bloated inventories are the last of six steps that the economy normally traverses on its way to a recession. Initially, we see economic overheating and a surge in inflation. In the current expansion, consumer prices declined briefly in 1986 because of the oil price collapse, but inflation rebounded to the 3.5% to 4% annual rate range it had been running and then rose to the 6% area.
Second, interest rates rise as credit markets become nervous over accelerating wages and prices, and the Federal Reserve pushes up rates to cool the over-exuberant economy. Third, housing, commercial construction and other interest-rate-sensitive sectors weaken in response to rising interest rates. Fourth, weaker construction slows growth in employment. Manufacturing employment growth remains strong until the peak quarter, but the moderation in construction drags down total employment growth. In today's economy, not only has construction employment growth slowed, but manufacturing jobs have also declined in the past two quarters. The fifth step is that consumers worry about the availability of jobs and increase saving while cutting spending. In normal fashion, consumers have been increasing their saving rate in the past two years.
The final step is that retailers, wholesalers and manufacturers are initially unaware of the slowdown in consumer spending--or ignore it--and inventories pile up. At this point in the business expansion, the conversations that I have had with my corporate clients during the past two decades are always the same.
"Do you have an inventory problem?" I ask. "No," the client responds. When I rephrase the question, "But have your inventory-to-sales ratios risen?" the answer is typically "Yes, a little bit, but . . ." And then follow all the technical, narrow explanations that guarantee that no generalized problem is developing. "We're having a sales contest, so we need extra inventories." Or, "We're missing a few parts for all these machines, but don't worry, we'll have them soon and they'll all be shipped out by next week."
The auto industry is a prime example of the normal belated recognition of inventory problems, and its behavior this time is in keeping with past cycles. When car sales fell early last year, and inventories rose as a result, auto makers didn't scale back production, despite plenty of evidence that the long auto buying spree of the 1980s was over. Instead, they resolved to "sell our way out of this slump" with huge rebates.
The results were disastrous for Detroit. The pickup in sales was not enough to justify the rebates, and all three American firms lost money on their North American auto operations in the third quarter. In September, dealers had 1.57 million cars in inventory, the 60 days' supply that they normally desire. Even though production rates were cut substantially in October, inventories rose to 84 days' supply of cars on dealers' lots. In the first 20 days of December, sales fell to a 5.9-million rate, and industry analysts estimate that at year-end, General Motors had a staggering 101 days' supply, Chrysler 88 and Ford Motor 93.
Problems similar to those facing the auto industry are the norm throughout American business at the end of business expansions, as is the lack of understanding that an inventory imbalance is brewing. In the quarters just before recessions, there is very little if any rise in the inventory-to-sales ratio for all U.S. manufacturing and trade.
Typically, inventories climb in the early quarters of recessions. With the denominator of the inventory-to-sales ratio falling and the numerator rising, the ratio skyrockets--but only after the recession is well in progress. Preliminary data for October may be the beginning of this process. Total manufacturing and trade sales fell to $519 billion from $523 billion in September, while inventories rose from $791 billion to $794 billion and the inventory-to-sales ratio rose to 1.53 from 1.51.
Although inventory control efforts in manufacturing have been impressive in this decade, one must be careful in interpreting this historically low ratio--at least before the recent rebound--as a bulwark against inventory problems. While the inventory-to-sales ratios in manufacturing may be low by the standards of recent history, they may not be all that low compared to the levels of stock that manufacturers wish to hold. As a result of the innovations in manufacturing technology and in inventory management, and driven by the need to cut costs, the desired and feasible inventory-to-sales ratio for many manufacturers has actually fallen. It is this relationship between desired and actual stock-to-sales ratios, and not between today's ratios and yesterday's, that will determine how manufacturers respond to rising inventories.
Furthermore, the inventory control seen in this decade in manufacturing is not in evidence elsewhere. Because wholesalers and retailers generally have not had to face international competition, their inventory control efforts have been inadequate to prevent substantial rises in their inventory-to-sales ratios.
Inventories are very difficult to monitor for those involved in goods production and distribution, much less for outside observers who are trying to time the onset and depth of the next recession. Government data on inventories and inventory-to-sales ratios are very late in being reported--preliminary data for October was released in mid-December. And the data is extremely volatile and subject to revisions.
My approach is to watch consumer spending, where data is more reliable and more timely, especially the large and volatile auto spending component. If consumer spending remains weak in coming months, it's a pretty good bet that many are building inventories that sooner or later they will regret.