If Businesses Reduce Their Inventories in the First Quarter, the Economy Will Shrink

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Thursday, 30 January 2014 21:16

Firms added inventories at a record $127.2 billion (in 2009 dollars) annual rate in the fourth quarter of 2014. This increase did not draw much attention because it was only $11.5 billion above the third quarter pace, adding 0.44 percentage points to GDP growth in the quarter. The extraordinary pace of inventory growth in the last two quarters means it is likely that inventory growth will slow in future quarters, which will be somewhat of a drag on growth.

However, it is worth noting that we are likely looking at a slower rate of inventory growth in future quarters, not actually a decrease in inventories as has been suggested in several reports. If inventories were to actually decline (which they almost never do outside of recessions) then it would be a huge drag on growth almost certainly pushing GDP in negative territory. Just to take a simple case, if inventories stayed flat in the first quarter, then the rate of inventory accumulation would have fallen by $127.2 billion, in a single quarter. This would translate into roughly a $508.8 billion annual rate of change (the quarterly rate multiplied by four). With GDP at roughly $16 trillion (in 2009 dollars), this would knock roughly 3.2 percentage points off the rate of growth in the quarter.

Since the underlying rate of growth is almost certainly less than 3.0 percent at the moment, the flatlining of inventories would push growth into negative territory. Even a modest fall in inventories would virtually guarantee a substantial drop in GDP in the first quarter.