UK suffers from global inventory shake-out
Monday 11 September 1995
Second, the current desire to believe that the consumer is weak knows no bounds. Nor is it affected in the least by published figures, which in fact show that growth in retail sales volume hit bottom last winter, and is now running at a 4 per cent annualised pace.
Certainly, car sales were not exactly rip-roaring in August (only the fourth-highest month in history), and anything even vaguely connected to housing or construction is very weak indeed. But elsewhere, in the unglamourous areas where we spend most of our money, goods have generally been moving off the shelves at a reasonable clip.
It is that phrase "off the shelves", though, which holds the key to the current conundrum, both here and overseas. In all the large economies, the swing in the growth rate experienced in recent quarters has been entirely dominated in both directions by the behaviour of stocks.
In the middle of last year, the bloc of big developed economies was growing at a quarter-on-quarter annualised rate of around 4 per cent, and roughly 2 per cent of this came not from consumption, not from investment, not from exports, but from stocks. Clearly, a dangerous mix.
Sure enough, by the second quarter of this year, the GDP growth rate had fallen to only 0.8 per cent, and the contribution of stocks had dropped to -0.8 per cent. Thus, GDP growth fell by 3.2 percentage points within 12 months, and the downturn in inventories contributed 2.8 percentage points of this decline. The implication is, of course, that there was little or no deceleration in other items of global spending between the boom of 1994 and the sharp slowdown of 1995.
So far, the UK has fitted into the global pattern mainly through the impact that the foreign stock cycle has had on the demand for our exports. Just when we had all become accustomed to a "dual" economy, in which exports were booming and the domestically insulated sectors were weak, this pattern was turned completely on its head. Exports have been flat since the middle of last year and foreign trade flows subtracted almost exactly 1 per cent from the growth of GDP in the second quarter. Meanwhile, both consumption and investment have recovered.
Really worrying, though, was the fact that one of the main contributors to growth during the second quarter - at least, according to our somewhat ropey GDP statistics - was the largest build-up in stocks seen during the current cycle.
There is nothing unusual in a modest increase in stocks during an economic upswing, but the annualised growth rate in goods on the shelves in the second quarter was as high as 5.8 per cent, while final sales of goods slipped by 0.6 per cent. Hence the ratio of inventories to sales rose quite markedly, and there is some evidence from business surveys that firms did not intend this to happen.
For most of the past 15 years, the inventory/sales ratio has been on a sharply downward trend, partly as a result of new techniques that have enabled firms to monitor demand more accurately, and to despatch goods to their final sales outlets more rapidly. Any significant rise in the inventory ratio relative to this downward trend is worrying, since it implies that firms may have accumulated undesired stocks as a result of a sudden slippage in sales, especially for the export market.
David Walton, of Goldman Sachs, has estimated that if manufacturing companies attempt to bring the stock ratio swiftly back down to its long-term trend, the necessary decline in stocks would be pounds 3bn, which would have a calamitous effect on GDP growth for a short while.
The short-term power of the stock cycle has been amply demonstrated in the recent slowdown in the US economy. Consumption and investment growth in the US remained well above trend in the first half of this year, despite the continuing talk of actual or impending recession. However, for a short while in the late winter, companies became concerned that they were building inventories somewhat faster than they desired, and they acted with extraordinary speed to stop this happening.
In the past, economists have been able to see this coming, since the inventory/sales ratio has risen for a few months before companies have been able to take off-setting action. This time, they took action almost before the ratio started to rise at all, demonstrating the improved information flows they have at their fingertips, as well as their improved ability to fine-tune production. The silver lining in these developments is that really large and sudden adjustments in inventory levels - which have been the precipitating causes of big recessions in the past - become less likely. But output may be more volatile and difficult to forecast for short periods as stocks adjust to minor deviations from desired levels.
In the US, the turndown in stocks cut the GDP growth rate by 1.3 per cent in the second quarter, and will probably knock a further 1.5 per cent off the growth rate in the current quarter. There are good reasons for believing that the stock shake-out in the US is nearing an end, in which case the growth in GDP should soon start to recover. But in Europe and Japan, the stock shake-out is less advanced, and could have at least another three months to go. And the same applies to the UK. In the second half of this year, we will probably get a succession of below-par output statistics as companies get the stocks ratio down to desired levels.
Provided that the growth in consumption and investment in Britain remains reasonably robust, this stock shake-out will have only a temporary effect on GDP growth, which will re-accelerate sharply next year when stocks stabilise. But in most other countries, central banks have chosen to reduce interest rates slightly as an insurance policy against the possibility that the stock shake-out will drag the rest of the economy down with it.
In the UK, the Governor of the Bank of England (rightly in my view) believes that fine-tuning interest rate policy in this way is likely to prove counter- productive, since it will boost activity next year when the economy is recovering, anyway. So he recommends leaving interest rates unchanged for the time being, while recognising that the inflation target will probably be missed unless there are further base rate increases next year.
This seems to me a sensible compromise. But it is becoming ever more likely that the Chancellor will again overrule Eddie George and cut base rates, anyway.
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