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• What Is the Natural Level of Inventories?

Transcript

Tim Sablik: My guest today is Thomas Lubik, a senior advisor in the Research department at the Richmond Fed. Thomas, welcome back to the show.

Thomas Lubik: Thanks, Tim. Thanks for having me back.

Sablik: Today we're going to be talking about inventories, which are goods held by businesses, either as inputs into future production or as finished products ready for sale. You've been studying the flow of inventories to see what economic policymakers can learn from them, and we'll include a link to a recent piece that you wrote about this.

To start our conversation off, even though I gave kind of a rough definition of inventories there in the beginning, maybe you could provide a little more detail about what sort of things economists mean when they talk about business inventories and what sort of data we have to track it.

Lubik: Very generally speaking, inventories are stocks of goods held by businesses at various stages of the production and the distribution process.

Holding inventories is costly. It is a forgone sale. It has carrying costs — if you have wheat inventories, for instance, parts of it [are] being eaten by rats and mice. It's basically money embodied in inventories that doesn't really produce anything. So, firms want to keep their stock of inventories fairly low.

We typically aggregate the individual types of inventories into various categories. The Bureau of Economic Analysis that produces most of the inventory statistics classifies three broad categories of inventories: manufacturing, that includes raw materials, work in progress, and finished goods; wholesale inventories, these are intermediary goods for resale to other businesses; and then retail inventories. Economists have analyzed these inventories at these levels of disaggregation.

Sablik: You mentioned the Bureau of Economic Analysis is where this data comes from. How is that data collected? Are firms reporting inventories to them?

Lubik: Yes, they are. It's actually a very involved process.

The raw initial inventory data come from the Census Bureau. It's largely based on surveys of all different kinds of companies and businesses in the U.S. For some very central and critical firms, it's mandatory to report on the inventory levels. What these businesses are required to report are their inventory holdings, their nominal value, at the end of the month. Then, the Census hands over this data to the Bureau of Economic Analysis and the BEA then produces the aggregate inventory data that go into the National Income and Product Accounts.

What is very tricky about this is that the inventory levels are reported in dollar values as nominal terms. So, this has to be converted into real terms. The BEA does this adjustment. On top of that, there are different types of accounting practices for how inventories are valued — last in, first out; first in, first out; and all of this. So, the BEA adjusts all that. It's a very involved process to end up with this one number, inventory investment, as a small but very important component of aggregate investment and GDP.

Sablik: When you look at this inventory investment or inventory levels in your research, you can see that it's pretty volatile. The levels move around a lot month to month. What are some of the reasons for that fluctuation?

Lubik: Inventory investment is, by far, the most volatile component of GDP. At the very basic level, inventory is goods that haven't been sold. They stay in the warehouse. So, what matters for the stock of inventories is demand conditions. If consumers do not show up during a certain period — a day or a month — then inventories will build up. But inventories also depend on supply conditions. For instance, manufacturers like to hold inventories to keep a continuous production process. If there's a disturbance in the supply chain, they may run low of inventories.

Businesses have to plan demand and supply conditions. At the individual level, this is a process that business people know very, very well. In fact, inventory management is a central component of any business education. But putting together all these individual movements at the firm level into an aggregate number makes this a very volatile component.

Sablik: Amid all this movement and volatility, is there a "normal" long-term level for inventories that we see in the economy?

Lubik: Yes, there is, and that's also a very interesting facet of inventories. This is probably best looked at in terms of the inventory-sales ratio. It's the ratio of the stock of inventories to sales over a certain period or the requirements for production.

The inventory-sales ratio tends to be fairly stable, but we see large differences in the inventory-sales ratio between the three large components. For instance, the aggregate inventory-sales ratio is about 1.3, which means that for every sale over a certain period, the stock of inventories is 1.3 times as much. Manufacturing inventory-sales is at 1.6. Merchant wholesale inventories, which stand between manufacturing and retail, that's about 1.3. Retail inventories are also around 1.3, but they've also moved around quite a bit.

So, what we see in the data — and this is what I would like to call the normal level of inventories — is stable for a good while, and then there are sudden changes.

Sablik: On the topic of sudden changes, has this normal level of inventories changed over time? I'm guessing the answer is yes based on ...

Lubik: Yes, yes, it has changed over time.

We do have inventory data going back throughout the 20th century. Manufacturing inventory-sales ratios have stayed at fairly high levels, around 2 — the stock of inventories was twice as high as the sales. Then, throughout the 1950s, '60s, '70s, the inventory-sales ratio for manufacturing was about 1.8. Then it dropped by the mid-2000s to 1.2 and then it started rising again. The combination of just-in-time manufacturing, better supply chains, and better management of the supply chains led to a dramatic decline in the inventory-sales ratio in manufacturing.

We see the same pattern for retail inventories. That started a little bit later in the 1990s but can presumably be associated with a fairly well-known large online retailer who also improved management of the current inventory stock.

Sablik: Aside from these long-running changes and trends, when else do we see deviations from the normal level of inventories?

Lubik: So, I talked about these big structural changes. But, of course, we also see deviations from the long-run levels that are only temporary or transitory. This comes down to the shocks that the economy or that the businesses experience. I gave the example before if there's a sudden drop in demand, firms may accumulate inventories because they cannot really make the sales. Typically, these demand shocks tend to dissipate after a while. Firms then will have to rebuild to get back to the normal inventory level. But these are only transitory effects.

Sablik: Speaking of shocks, we've definitely experienced some economic shocks and heard a lot about inventories in recent times. What happened to inventories during the COVID-19 pandemic?

Lubik: What we saw at the beginning of the pandemic was actually quite fascinating in terms of the behavior of inventories. The ratio of inventories to sales spiked. The reason for this is that for several weeks, for almost a quarter, the economy was shut down. There were effectively no sales. We saw a big decline in consumption, so firms didn't deplete their inventories. They, in fact, accumulated them. Once the economy reopened, there was a lot of pent-up consumption demand. Sales increased and inventories were depleted.

What is so fascinating is that even almost five years after the pandemic, retail inventories still have not been entirely rebuilt. They are still below the level of pre-COVID by about 10 percent while manufacturing inventories are now at a higher level. This is a little bit of a puzzle.

What one could think is that manufacturers, because of the issues with supply chains, have become a little bit nervous and moved away from just-in-time manufacturing and now like to hold higher inventories. The same doesn't quite apply to retailers. It is probably evidence of fairly strong consumption demand.

Sablik: Do we have any data yet on inventory responses to the tariff changes, or is that still forthcoming?

Lubik: At some level, it is still forthcoming. The big question is, how do the tariff-induced shifts in the economy affect desired or normal levels of inventories?

After the announcement of the big increases in tariffs on imported goods on what has been called Freedom Day, businesses started to panic and imported quite a bit and rebuilt and built up their inventories. Inventory investment spiked considerably. Then in the next quarter, it essentially reversed.

Sablik: Thinking about that movement in particular, do large fluctuations in inventories away from the normal pattern have any effect on the health of the economy overall? There was some talk about movements in GDP numbers related to changes in inventories. Or, should we think of them more like a signal rather than something that's actually moving the economy itself?

Lubik: I have a very strong viewpoint on this. I would argue that no, there is no impact on the economy. I would even go so far in saying that at the aggregate level, inventory investment is essentially noise. There are always shocks hitting the economy and it's very hard to figure out what makes an inventory behave in a certain way month by month or even quarter by quarter. Is it demand shocks? Is it supply shocks?

For an inventory manager at the level of a business, this is a completely different story because I know what my demand conditions are. I know what my supply conditions are. If I see that my inventory is depleted, I'm trying to build it up. The macroeconomists don't have that luxury. We cannot pinpoint exactly the sources of demand and supply shocks affecting inventories, unless, of course, we have a very noticeable shock like COVID or the tariffs.

Sablik: Thomas, thank you so much for joining me today to talk all about inventories.