Quarterly reports on real gross domestic product usually say more about where we've been than where we're going. Washington's data on first-quarter GDP, due on Apr. 29, will certainly have some bad news about growth last quarter, but it may well offer some good news about the second half. That's because several monthly reports imply that businesses have been slashing production at a much faster rate than overall demand has dropped off. As a result, the GDP data will most likely show a supersized liquidation of business inventories that is laying the groundwork for a stabilization in GDP.
Inventory adjustments—and the production cutbacks that accompany them—always play a major role in a business cycle. In past downturns, reducing excessive stockpiles amid weaker demand has typically accounted for about two-thirds of the drop-off in GDP, with falling demand making up the rest. This inventory purge also sets up the economy's natural snapback in a recovery. As inventories come into better balance with sales, companies start ordering again, and production stops falling, setting the stage for renewed growth.
The latest report will likely show that process is already well advanced. Economists expect first-quarter GDP to have declined at about a 5% annual rate, following the fourth quarter's 6.3% drop. They believe about half of that contraction reflects shrinking inventories. Several economists are looking for an inventory decrease close to $100 billion, after adjusting for inflation, which would be the largest quarterly liquidation on record.
One reason for the outsize shrinkage in stockpiles: The decline in overall demand appears to have been much less severe than in the fourth quarter. Both home building and capital spending by businesses are expected to post steep drops, but the surprise stabilization in consumer spending and a narrower trade deficit provided some offset. Consumer spending appears to have grown about 1% after huge declines in the second half of 2008.
Moreover, as the contraction in demand eased, the plunge in manufacturing output continued to intensify, helping to speed up the inventory adjustment. Factory production plummeted at a 22.4% annual rate in the first quarter after falling 18% in the fourth quarter. In particular, output of consumer goods declined almost 15% last quarter, even though spending on these items appears to have grown about 3%. That disparity implies an enormous drawdown of inventories. Plus, another big liquidation is likely this quarter as production cuts continue while demand gets support from Washington's stimulus package.
Nascent progress in bringing stockpiles into better alignment with demand shows up in the ratio of business inventories to sales. This gauge turned down in February after increasing steadily and sharply since the middle of last year. Most of that rise occurred because of the sudden decline in sales, which dropped 16% in the second half of last year. But since December, stockpiles have fallen 2 1/2 times faster than sales, and the ongoing liquidation will continue to push the ratio lower in coming months.
One area where the inventory adjustment will drag on for a while is machinery and high-tech gear, reflecting huge cutbacks in capital spending. Equipment outlays sank at a 28.1% annual rate in the fourth quarter, the largest drop in 50 years, and first-quarter spending is expected to have posted a similar fall. In February manufacturers' ratio of inventories to sales for machinery and electronic equipment was the highest in 15 years. Factories are slashing production, and the cutbacks in high-tech gear far surpass even those during the tech bust in 2000.
Nevertheless, the traditional inventory cycle is starting to turn. Inventories will most likely have exerted their greatest drag on growth in the first quarter. Heavy cuts now will clear the way for at least a modest resumption in GDP growth in the second half, as businesses lift output to a level that's in better balance with sales.