Changes in Inventories

The ABS reports that, in terms of expenditure, the largest negative contribution to GDP in the December quarter of 2008 was from inventories. Does the significant reduction in inventories provide any information as to where the Australian economy is headed? It depends, of course, on why firms reduced their inventories. On the one hand, the reduction in inventories may have been intentional, in response an anticipated reduction in demand. On the other hand, the reduction in inventories may have been unintentional (due, for example, to unanticipated strength in retail sales), and firms will need to increase inventories next quarter to restore them to some target level. The latter bodes well for economic activity next quarter, the former does not.

With improvements in inventory management, and the associated reduction in stock levels to sales over the last three decades, the recent reductions in inventories suggest reason for pessimism. As far back as 1993, the Reserve Bank of Australia noted that:

when firms expect demand to increase they also expect their stocks to increase. There is no evidence that firms have a strong desire to smooth production and meet expected changes in demand out of stocks. Instead, when demand is expected to increase, both output and inventories are also expected to increase. While the effects of unexpected demand changes on inventories have become more muted, the response to expected changes has increased.