Donald S. Allen

English

Research Papers in Economics

NationalEconomicTrends
August 1998
Old Wine at New Prices 
The real change in business inventories (CBI) 
in the first quarter of 1998 was a whopping $91.4 
billion chain-weighted 1992 dollars at a seasonally
adjusted annual rate.  The increase contributed 1.2
percentage points to the spectacular 5.5 percent
growth in real gross domestic product (GDP) for the
quarter (see chart at the bottom of Page 4). However,
the monthly changes in manufacturing and trade
inventories did not appear to be as large; the chart 
on Page 5 shows that the monthly inventory-to-sales
ratio did not rise significantly.  The monthly increases
in manufacturing and trade inventories in current dol-
lar terms are less than they were in 1994-95. But the
CBI component of GDP is larger—both in nominal
and real terms.  
GDP is supposed to measure the value of cur-
rent quarter production, but since some firms use
accounting practices that report inventory with-
drawals at historical (book) cost, an inventory 
valuation adjustment (IVA) is necessary to calcu-
late CBI.  The IVA uses producer price indexes 
to adjust the value of inventory withdrawals to
reflect profits or losses from price changes that
took place since the inventory was produced.
When producer prices rise, IVA is negative and
reduces the change in the CBI.  When producer
prices fall, IVA becomes positive.  
The accompanying chart shows the change 
in book value and the IVA for nonfarm invento-
ries.  During the 1994-95 inventory accumulation,
producer prices were rising, and IVA deducted
from the change in the book value of nonfarm
inventories.  In 1997 and the first quarter of 1998,
however, falling producer prices made the inven-
tory valuation adjustment positive and added to
the increase in the book value of inventories.  
As a result, the CBI component of GDP was high-
er, even though the book value of inventories
increased less during 1997 and the first quarter of
1998 than in 1994-95.
Both the real and nominal manufacturing and 
trade inventory-to-sales ratios have been low and
steady for the past few quarters.  This would lead us
to conclude that inventory levels are not out of line.
So, in one sense, we can argue that the IVA exagger-
ates the amount of the inventory buildup.  But in a
period of declining prices, there is an additional penalty
for holding too much inventory.  When prices are
falling, firms want to minimize their stocks of inputs
and finished goods, deferring purchases and produc-
tion until needed.  If producer prices continue to fall,
firms might set lower-than-normal targets and reduce
planned inventory levels.
Preliminary data indicate signs of a slowdown in
inventory investment in the second quarter of 1998, but
low inventory-to-sales ratios suggest that an inventory
correction would be fairly mild, unless other forces
combine to dampen consumption and investment.
—Donald S. Allen
Views expressed do not necessarily reflect official positions of the Federal Reserve System
Components of Nonfarm 
Business Inventory Investment
150
100
50
0
-50
-100
1994 1995 1996 1997 1998
Billions of Dollars
Inventory Valuation Adjustment
Change in Book Value
Change in Inventories

Old wine at new prices

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Old wine at new prices

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