23 November 2011 – Macro Insight

Macro Insight: Santa’s Empty Workshop

During last year’s holiday season, US retail sales returned to pre-recession levels. This year they are surging to new highs. Skeptical retail stores, however, are keeping inventories low. Maybe too low.

In earlier decades, inventory management used to be largely reactive to the ebb and flow of the economy. When the economy slowed, inventories built up and production was cut until the shelves were cleared, after which production eventually resumed. During the inflation of the 1970s, there was even an incentive to hold excess inventory: companies could book profits merely by buying extra quantities of stock to sit in their warehouses. Against that backdrop, the ratio of inventories to sales climbed ever higher.

An inventory revolution finally hit in the late 1980s. Inflation peaked and the cost of raw materials began a multi-decade decline, reversing the incentive for companies to buy excess inventory. Meanwhile, new thinking was gaining ground in Japan that recognized the hidden costs of excess inventories: storage fees, misallocation of resources, and the risk of holding outdated inventory, particularly in technology and other fast-paced industries. Instead of stockpiling, the new approach delivered supplies to the factory gates just in time for production. After just-in-time techniques went global, inventory cycles became less pronounced and the inventory-to-sales ratio plunged. The question is just how low can it go.

Today, “just in time” can take too long. With inventories so lean, the global economy is increasingly vulnerable to supply chain disruptions. In 2010, a volcano in Iceland interfered with the delivery of machinery parts to Asia. In 2011, Japan’s earthquake disrupted auto production all the way back to Europe. More recently, floods in Thailand shut down the production lines of hard-drive manufacturers and shortages loom throughout the computer industry.

Moreover, low inventories could reflect an overly pessimistic assessment of the economy’s near-term prospects. Inventory-to-shipment ratios are near cycle lows for US businesses broadly and are at all-time lows at retail stores. Despite the glum forecasts, consumers continue to spend and, to judge by the latest Gallup surveys, are planning on spending even more this season. With global supply chains being disrupted and inventory levels so low, the risk for holiday shoppers is that the shelves are empty before the stockings are full. In that event, the most popular present might turn out to be gift cards.

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