An important but quiet adjustment is playing out successfully in the 2007 economy: U.S. companies are slowing inventory growth in line with slowing economic growth. Business Inventories data released on May 11 showed a 0.1 percent decline for March to a year-on-year pace of 4.8 percent. The year-on-year pace is still above the 3.7 percent pace for business sales, data also released in the Business Inventories report, but the gap has been narrowing in recent months. Just six months ago, both business inventories and business sales were at the 8 percent pace.

Changes in inventories are a key piece of GDP data and the dip in inventories will be a negative for GDP revisions, when the data are released at the end of the month. In fact, inventory contribution to GDP has been flat to negative for the last three quarters. But in this case, a negative is a positive.

Slower growth is the central policy goal at the Federal Reserve which is trying to ease pressures on inflation. But more importantly, slower inventory growth reduces the risk of inventory overhang -- that is the build-up of unwanted inventory. Overhang, an imbalance that can take a non-incremental chunk out of economic growth and employment, is an early and predictable risk during economic slowing.

Business Inventories is one of several inventory reports on the economic calendar. Inventory data begin unrolling at month end with Durable Goods Orders, but we'll save this, which is a particularly interesting report, for a little later. We'll start with the second report, Wholesale Trade which is released in the first week or so of the month. In the graph below, the ascent of inventories at the wholesale level, the blue field, hasn't shown much change over the past several years in contrast to wholesales sales, the red line, which actually broke into a brief descent late last year.

Note the relative size of inventories to sales, at just under $400 million in the latest month for inventories and about $350 million for sales (far right in above graph). The ratio of inventory-to-sales, thanks to productivity, has been narrowing steadily over the years as it has in the wholesale sector, from about 1.25 in the late 80s to 1.14 in the latest data ($400 million/$350 million). This ratio ballooned to 1.32 at the worst of the last recession in 2001, a time, as shown by the blue swollen lump in the graph above, when the inventory wave seemed to lag the sales wave.

Business Inventories which are released at mid-month, sum up the monthly reports and include previously unreleased numbers on retail inventories. Supply chain productivity, boosted in recent years by business-to-business purchasing systems, is also evident in the retail sector where the inventory-to-sales ratio declined from 1.70 in the late 80s to less than 1.50 now. During the last recession, the ratio swelled to about 1.60.

Turning now to factory inventories which are released in two sets of data, beginning with Durable Goods Orders at month-end followed shortly by Factory Orders. The latter includes revisions to the durables data and data on non-durables (a category led by food and petroleum). We're going to focus on the durable goods side where inventories are headed by such categories as machinery, aircraft, and fabricated metal products, where lead times are counted in years. Other categories include metals where prices and availability can change quickly, as demonstrated in the aftermath of Hurricane Katrina.

Evidence of supply chain improvements are very clear on the durable goods side (the graph below). The inventory-to-shipments ratio moved steadily from about 2.00 in the late 80s to about 1.50 at Y2K. The ratio rose to 1.65 during the depth of the 2001 recession, hit a low of 1.31 during the peak of the expansion early last year and is now at 1.44. The widening ratio in recent months can be seen at the far right of the graph below, as the blue tide rises while the red line sags.

Though inventory growth hasn't quite slowed as much as sales growth, the worst seems to have passed. Inventory readings in the ISM Manufacturing and ISM Non-Manufacturing reports both showed rare drops at the beginning of the year suggesting that companies entered the year fearing the worst. But as orders have proven to be solid, inventory accumulation has resumed. (See March 7, 2007 Short-Take, "ISM Inventories Point to Smooth Moderation").

For the investor, inventory readings mostly offer a lagging look at the markets. The graph below compares durable inventories with the S&P 500 Index. Inventories clearly lagged the big upturn into Y2K and lagged even further during the subsequent expansion. In fact the trench at 2004 brings up the psychological impact that inventory overhang can have on business behavior.

The 2001 recession hit the manufacturing sector hard. Unwanted inventory led to big layoffs at domestic factories that have never been recovered. A look at the graph above shows that inventory levels have also never recovered, with current levels still below the 2001 peak.

Unlike inventories, shipments and new orders (graph below) have fully recovered. However, they never showed the same depth of retrenchment during 2004 as did inventories. Companies were receiving orders and shipping out goods, but were not producing sufficient goods to build inventories to the same degree. Unlike inventories, shipments and especially new order data are clearly useful for tracking markets. New orders (light blue) showed a giant spike just before the peak in stocks at Y2K, and new orders were already steadying while stocks continued to sink 2002.

But there may be some inventory data that don't lag. The ISM Manufacturing Inventory Index offers an interesting comparison with the S&P 500 (graph below). The Inventory Index, which measures month-to-month change, peaked early at Y2K and recovered early during the expansion. But more recently, the Inventory Index has been sagging for about a year, in contrast to the stock market which has been gaining steam. The ISM's monthly reports are issued in the first week of the month.

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