Donald S. Allen

English

Research Papers in Economics

NationalEconomicTrends
March 1997
Lean Inventory
Corrections
Larger-than-anticipated inventory buildups can
lead to so-called inventory corrections, which can
push the economy into a recession as firms scale back
production and lay off workers.  There was some
speculation that inventory buildup in 1994 and 1995
might herald an inventory correction and recession in
1996.  Real increase in business inventories contributed
$58.9 billion to real Gross Domestic Product (GDP)
in 1994.  The 1995 increase in business inventories of
$33.1 billion was smaller, but could still be consid-
ered above average (see page 4).  Was this inventory
increase a cause for concern?
The inventory cycle is usually marked first by a
rise, then a fall in the inventory-to-sales ratio.  The
ratio first increases, as a result of both the rise in
inventory and the slowdown in sales at the beginning
of a downturn, then falls as inventory over-
hang is corrected and sales pick up.  Inventory
investment began to increase in the second
quarter of 1994, while the ratio of inventory to
sales remained more or less flat.  But the
inventory-to-sales ratio had been declining
since the 1990 recession and, by early 1994,
was at its lowest in over two decades.  So a
flat ratio in 1994 reflected an end to the
decline and, by 1995, the rising inventory
investment began to show up as an increase in
the ratio (see charts on this page and page 5).
This led to the speculation by some that inventory
levels were higher than desired.
To reduce the ratio, a correction to the
growth of inventory was necessary.  As the
chart shows, reduced inventory growth in 1996
lowered the inventory-to-sales ratio even
below the early 1994 level.  Although inventories
have again begun to increase, the ratio has
remained low and fairly steady for a number of
months.  This suggests that inventories are now
increasing in line with sales, not faster than sales, and
therefore should not require further correction.  In
addition, the correction did not result in severe inven-
tory reductions, which would have subtracted from
GDP.  Instead, a slower rate of inventory growth was
all that was required to bring inventory back in line
with sales.
Because firms had been maintaining lean invento-
ries, as indicated by the low inventory-to-sales ratio,
the buildup was not as acute as it might otherwise
have been, and the subsequent correction has not
been as painful.  A similarly mild inventory correc-
tion occurred in the middle of the expansion period 
in the 1980s.  
The economy is subject to occasional inventory
imbalances which lead to corrections.  Fortunately,
some inventory corrections, like this recent one, are
not severe enough to precipitate a recession.
—Donald S. Allen
Views expressed do not necessarily reflect official positions of the Federal Reserve System
    
 
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               Recession
Inventory-to-Sales Ratio:  Manufacturing and Trade

Lean inventory corrections

http://research.stlouisfed.org/publications/net/19970301/cover.pdf

Lean inventory corrections

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Research Papers in Economics