As many economists see it, the sharp downturn in the fourth quarter foreshadows a more moderate decline in the first quarter of 1991 and a relatively brief and mild recession. The reason, they say, is that business has kept inventories relatively lean during the past year, avoiding the kind of overbuilding that led to protracted problems during past cyclical declines.
Reduced inventory investment has, in fact, largely determined the severity of most past recesssions, accounting for an average 80% of the decline in gross national product. In a typical business cycle, stock-building picks up steam in the late stages of the expansion, partly because rising prices inspire speculative holdings. As sales decline in the ensuing recession, previously acceptable inventory levels turn rapidly excessive. And that prompts sharp cutbacks in production and employment to bring stocks back in line with diminished demand.
Inventory-building has been markedly restrained this time around, however, judging by the inventory-to-sales (IS) ratio in manufacturing and trade. It registered only 1.47 in October, just a tad above August's 1.46, which was the lowest reading since 1981.
The key factor in the improved inventory picture has been the behavior of manufacturers. By adopting just-in-time inventory-control systems, factory managers have been able to pare their IS ratios throughout the expansion, bringing them close to their historic lows. "That means output adjustments to falling demand are quicker and smaller," says economist Maury Harris of PaineWebber Group Inc., "so the recession should be shorter and milder."
Other economists aren't so sure. A. Gary Shilling of the consulting firm that bears his name points out that "inventory-to-sales ratios usually do not explode until after a recession begins, and recent IS ratios for the overall manufacturing and trade sectors are higher than they were at the outset of two of the past three recessions."
More important, as factory inventory-sales ratios have fallen during the expansion, retail IS ratios have moved to historic highs (chart). This trend may be related to the overbuilding of retail outlets and the inability of small retailers to use point-of-sale terminals to manage inventories. But whatever the cause, says economist Richard B. Berner of Salomon Brothers Inc., "manufacturers have been able to push some of the burden of holding stocks onto retailers."
The upshot, say Shilling and Berner, is that the coming inventory correction is likely to be more pronounced than many observers expect. "Factory inventories may look lean," says Shilling, "but the key question is how they compare with desired levels. By that standard, they're likely to look increasingly excessive to manufacturers, as retailers cut orders to reduce their own stocks."