Contribution to GDP Growth of the Change in Inventories: Econ 101 Again

A.  Introduction

The contribution of changes in inventories to changes in reported GDP is easily misunderstood.  One saw this in reports on the recent release (on July 28) by the Bureau of Economic Analysis (BEA) of its first estimate of GDP for the second quarter of 2022.  It estimated that GDP fell – at an annualized rate of -0.9% in the quarter – and that along with the first quarter decline in GDP (at an estimated rate of -1.6%), the US has now seen two straight quarters of falling GDP.  While there will be revisions in the coming months of the second quarter figures, as additional data become available, a fall in GDP for two straight quarters has often been used as a rule of thumb for an economy being in recession.

News reports on the figures noted also that were it not for the estimated change in inventories, GDP would have gone up rather than down.  The estimate was that GDP fell by -0.9% (at an annual rate) in the second quarter, and that the change in private inventories alone accounted for a 2.0% point reduction in GDP.  That is, if the inventory contribution had been neutral, GDP would have grown by about 1% rather than fallen by almost 1%.

But it would be wrong to attribute this to “decreases in inventories”, as some reports did.  Inventories grew strongly in the fourth quarter of 2021, with this continuing at a similarly strong pace in the first quarter of 2022 and still (although at a slower pace) in the second quarter of 2022.  How, then, could this have contributed to a reduction in GDP in 2022?

It is easy to become confused on this.  While really just a consequence of some basic arithmetic, it does require a good understanding of what GDP is and how changes in inventories are reflected in GDP.  I discussed this in a January 2012 post on this blog, but that was more than a decade ago and a revisit to the issue may be warranted.  This post will examine the problem from a different perspective from that used before.  It will start with a review of what GDP measures, and then use some simple numerical examples to show how changes in inventories affect GDP.  It will then use a series of charts, based on actual numbers from the GDP accounts in recent years, to show how changes in inventories have mattered.

A note of the data:  All the figures used come from the BEA National Income and Product Accounts (NIPA), as updated through the July 28 release.  These are often also called by many (including myself) the GDP accounts, but NIPA is the more proper term.  Also, the figures for inventories in the NIPA accounts are for private inventories only.  Inventories held by government entities are small and are not broken out separately in the accounts.  Instead, changes in such inventories are aggregated into the figures for government consumption.  While I will often refer to “inventories” in this post, the measures of those inventories are technically for private inventories only.

B.  Inventories and GDP, with Some Simple Numerical Illustrations

GDP – Gross Domestic Product – is a measure of production (product).  Yet as anyone who has ever taken an Econ 101 class knows, GDP is typically described as (and measured by) how those goods and services are used:  for Consumption plus Investment plus Government Spending plus Net Foreign Trade (Exports less Imports).  In symbols:

GDP = C + I + G + (X-M)

Where “C” is private consumption; “I” is private investment; “G” is government spending on goods or services for direct consumption or investment; and “X-M” is exports minus imports, or net foreign trade.

(Imports, M, can be thought of either as an addition to the supply of available goods or netted out from exports, X, to yield net exports.  To keep the language simple, I will treat it as being netted out from exports.)

Private investment includes investment both in new fixed assets (such as buildings or machinery and equipment) and in accumulation of inventory.  This accumulation of inventory, or net change in inventory, is key to why this equation adds up.  As noted above, GDP is product – how much is produced.  Whatever is produced can then be sold for consumption, fixed asset investment, government spending on consumption or investment, or net exports.  If whatever is produced exceeds what is sold in the period for these various purposes, then the difference will accrue as inventories.  If the amount produced falls short of what is sold, there will have to have been a drawdown of inventories for the demands to have been met.  Otherwise it would not have been possible – the goods had to come from somewhere.

The balancing item is therefore the change in inventories.  It is what allows us to go from an estimate of what is sold to an estimate (if one knows how much inventories changed by) of what was produced, i.e. to Gross Domestic Product.

How then do changes in inventories affect measured GDP?  This is best seen through a series of simple numerical examples, tracing changes in the stock of inventories over time.




Change in the Change










Start with a stock of inventories in the economy as a whole in period 0 of say 2000 (in whatever units – perhaps billions of dollars).  This stock then grows to 2200 in period 1 and 2400 in period 2.  The change in inventories in period 1 will then be 200, and that change in inventories will be one of the components making up GDP (along with private consumption, private fixed investment, and so on).  It is an investment – an investment in inventories – and thus one of the uses of whatever product was produced in the period.  It will equal the total of what was produced (GDP) less what was sold for the sum of all final demands (private consumption, private fixed Investment, government, and net foreign trade).

With the stock of inventories growing to 2400 in period 2, the change in inventories in that period will once again be 200.  Hence the contribution to GDP will once again be 200.  This is the same as what its contribution to GDP was in the previous period, and hence the higher inventories would not have been a contributor to some higher level of GDP – its contribution to GDP is the same as before.  The change in the change in the stock of inventories is zero.

But this does not mean that inventories fell in period 2.  They grew by 200.  But that was simply the same as its accumulation in the prior period, so it did not add to GDP growth.

To make a contribution to GDP growth in period 2, the addition to inventories would have had to have grown.  For example:




Change in the Change










In this example, the stock of inventories grew to 2500 in period 2.  The change in inventories was then 300, which is higher than the change in inventories of 200 in period 2 – it is 100 more.  This would be reflected in a GDP in period 2 which would be 100 higher than it would have been otherwise.

If, on the other hand, the pace of inventory accumulation slows, then inventory accumulation will subtract from GDP:




Change in the Change










In this example, inventories are still growing in period 2 – to a level of 2300.  This is 100 higher than what it was in period 2.  But the change in inventories is then only 100 – which is less than the change of 200 in period 1.  Inventories are still growing but they will add less to GDP than they had in period 2.  Hence they will subtract from whatever growth in GDP there might have been otherwise.

This is what happened in the recently released estimates for GDP growth in the second quarter of 2022.  Inventories were still growing, but they were growing at a slower pace than in the prior quarter.  In terms of annual rates (and with seasonally adjusted figures), inventories grew by $81.6 billion in the second quarter (in terms of constant 2012 dollar prices; see line 40 of Table 3 of the BEA release).  But this was less than the $188.5 billion growth in inventories in the first quarter of 2022.  In percentage point terms, that difference (a reduction of $106.8 billion) subtracted 2.0% from what GDP growth would have otherwise been in the second quarter (see line 40 of Table 2 of the BEA release).  With the changes in the other components of GDP, the end result was that estimated GDP fell by 0.9% in the quarter.  Thus one can attribute the fall in GDP in the quarter to what happened to inventories, but not because inventories fell.  It was because they did not grow as fast as they had in the previous quarter.

C.  Changes in Inventories in the Data

Based on this, it is of interest to see how inventories have in fact changed quarter to quarter in recent years.  These changes, and especially the changes in the changes, are volatile.  They can make a big difference in the quarter-to-quarter changes in GDP.  Over time, however, they will even out, as there is some desired level of inventories in relation to their sales and producers will target their purchases to levels to try to reach that desired level.

Start with the chart at the top of this post.  It shows the stock of private inventories by quarter going back to 1998.  The figures are in constant 2012 dollars so that inflation is not a factor (and more precisely using what are called “chained” dollars where the weights used to compute the overall indices are based on prior period shares of each of the goods – so the weights shift over time as these shares shift).

Stocks generally move up over time as the economy grows, although there have been reductions in periods when the economy was in recession or otherwise disrupted.  Thus one sees a fall in 2001, due to the recession in the first year of the Bush II administration, an especially sharp fall in 2008 with the onset of the economic and financial collapse in the last year of the Bush II administration with this then carrying over into 2009, and then a fall again in 2020 due to the Covid lockdowns.  The trough in the most recent downturn was reached in the third quarter of 2021, following which the stock of inventories grew rapidly.  They are still, however, slightly below the level reached in mid-2019 even though GDP is higher now than what it was then.

One starts with the stocks, but as was discussed above, the contribution to GDP comes from the accumulation of inventories – the change in the stocks.  These changes, based on the figures underlying the chart at the top of this post, have been:

There is considerable quarter-to-quarter volatility.  Note that the figures here are expressed in terms of annual rates.  That is, they are each four times what the actual change was (in dollar terms) in the given quarter.  One sees that the change in the fourth quarter of 2021 was quite high – higher than in any other quarter of this 24-year period – and was still almost as high in the first quarter of 2022.  The increase was then less in the second quarter of 2022, but was still a substantial increase (of $81.6 billion at an annual rate) in the quarter.

The changes in inventories are a component of GDP, but the contribution to the growth in GDP comes from the changes in the change in inventories.  These are easily computed as well by simple subtraction, and were:

These are now very highly volatile, and one sees especially sharp fluctuations in the last couple of years.  With all the disruptions of the lockdowns, the subsequent supply chain disruptions, and the very strong recovery of the economy in 2021 (with GDP growing faster than in any year in almost four decades, and private consumption growing faster than in any year since 1946!), it has been difficult to manage production to meet expected demands and allow for some desired target level of inventories.

This had a substantial impact on the quarter-to-quarter changes in GDP, both positive and negative.  Focussing on the recent quarters, the changes in inventories were a $193.2 billion increase in the fourth quarter of 2021, and as noted before, a further $188.5 billion increase in the first quarter of 2022 and a further although smaller increase of $81.6 billion in the second quarter of 2022.  These were the changes in inventories.  But the changes in the changes, which is what will add to or subtract from GDP growth, were a very high $260.0 billion in the fourth quarter of 2021, and then a fall of $4.7 billion in the first quarter of 2022.  This reduction in the first quarter of 2022 came despite inventories increasing in that quarter by close to a record high level.  But they followed a quarter where inventories rose by a bit more, so the change in the change was small and indeed a bit negative.

In the second quarter of 2022 inventories again rose – by $81.6 billion.  But following the close to record high growth in the first quarter of 2022, its contribution to the growth in GDP in the quarter was substantially negative.  The $81.6 billion increase in inventories in the second quarter was $106.9 billion less than the increase of $188.5 billion in the first quarter.  And it is this $106.9 billion which is a contribution to (or in this case a subtraction from) what GDP growth would have been in the quarter.

Finally, one can show this also in the possibly more helpful units of the percentage point contribution to the growth in GDP:

Although in different units, the chart here mirrors closely the preceding one, as one would expect if one has been doing the calculations correctly.  The only difference, in principle, is that with GDP growth over time, the dollar values of the quarter-to-quarter changes will look larger when expressed as a share of GDP in the earlier years of the period.

There are, however, some minor differences deriving from the nature of the data used.  The chart here was drawn directly from the figures presented in the BEA NIPA accounts for the percentage point contributions to GDP growth from changes in inventories.  One can also calculate it by taking the quarterly changes in the change in constant dollar terms (from the preceding chart, in red), dividing it by the previous quarter’s GDP (as one is looking at growth over the preceding quarter), and then annualizing it by taking one plus the ratio to the fourth power.  I did that, and the curve lies very close to on top of the curve shown here (in orange).

But not quite, due in part to rounding errors that compound when one is taking the changes and then the changes in the changes.  In addition, inventories by their nature are highly heterogeneous, with some going up and some down in any given period even though there is some bottom line total on whether the aggregate rose or fell.  This makes working with price indices tricky.  The BEA figures are based on far more disaggregated calculations than the ones they present in the NIPA accounts, and their underlying data also have more significant digits than what they show in the tables they report.

D.  Inventories to Sales, and Near Term Prospects

What will happen to inventories now?  Given how important changes in inventories are to the quarter-to-quarter figures on GDP growth, economists have long tried to develop some system to predict how they will change (as have Wall Street analysts, where success in this could make some of them very rich).  But they have all failed (at least to my knowledge).

One statistic that many focus on, quite logically, is the ratio of inventory to sales:

The figures here were computed from data reported in the BEA NIPA Accounts, Table 5.8.6B, where inventories include all private inventories while sales are of goods (including newly built structures) sold by domestic businesses.  Inventories are by nature of goods only, and hence one should leave out services (as an increasing share of services in GDP would, on its own, lead to a fall in the ratio).  Sales of newly built structures are included as one has inventories of building materials.  The figures on the sale of goods by domestic businesses are provided by the BEA.  Note that “sales” here are expressed on a monthly basis.  Hence the ratio is of inventories in terms of months of sales.

As one sees in the chart, the ratio of inventory to sales has been coming down over time.  This is consistent with all the literature advising on tighter inventory management.  There was then an unusually sharp decline in 2020 – a consequence of the Covid lockdowns – that bottomed out in the second quarter of 2021 (as a share of sales) and has since grown strongly.  But the ratio is still below where it was prior to the pre-Covid trend, although how much below depends on how one would draw the trend line pre-Covid.

Where will it go from here?  While important to what will happen to the quarter-to-quarter figures for GDP growth, as discussed above, I doubt that anyone has a good forecast of what that will be.  While there might well be room for the inventory to sales ratio to rise from where it is now, keep in mind that the ratio can rise not only by adding to inventories but also by sales going down.  And while GDP growth was exceptionally strong in 2021, it has been weak so far this year (indeed negative) and that weakness might well worsen.  Personally, while I do not see that the economy is in recession now (employment growth has been strong, with 2.7 million net new jobs in the first half of 2022, and the unemployment rate has been just 3.6% for several months now), the likelihood of a recession in 2023 is, I would say, quite high.

There also have been recent announcements by major retailers that the inventories they are currently holding are well in excess of what they want, and that they will take exceptional measures to try to bring them down.  Target announced a plan to do so in June (with a warning it will squeeze their near-term profits), Walmart announced in July they had similar issues (and that it would slash prices to move that inventory), and other retailers have announced similar problems.  If this is indeed a general issue, then those efforts to bring down inventories in themselves will act as a strong drag on the economy, making a recession even more likely.  And as was discussed above, the stock of inventories does not need to fall in absolute terms to cut GDP growth – a change that is less than what the change had been in the prior period will subtract from GDP growth, even though the inventories may still be growing in absolute terms.

Firms such as Target and Walmart employ many highly trained professionals to manage their inventories.  Yet even they find it difficult to get their inventories to come out where they want them to be.  If they and others now begin a concerted effort to bring down their inventory levels in the coming months, the impact on GDP in the rest of this year could be severe.

GDP Growth in the Fourth Quarter of 2012: Cuts in Government Spending Drove GDP Down

Growth of GDP and Contri of Govt, 2007Q1 to 2012Q4

BEA release of 1/30/13; Seasonally adjusted annualized rates       Percent Growth Contribution to GDP      Growth (% points)
2012Q2 2012Q3 2012Q4 2012Q2 2012Q3 2012Q4
Total GDP 1.3 3.1 -0.1 1.3 3.1 -0.1
A.  Personal Consumption Expenditure 1.5 1.6 2.2 1.06 1.12 1.52
B.  Gross Private Fixed Investment 4.5 0.9 9.7 0.56 0.12 1.19
 1.  Non-Residential Fixed Investment 3.6 -1.8 8.4 0.36 -0.19 0.83
 2.  Residential Fixed Investment 8.5 13.5 15.3 0.19 0.31 0.36
C.  Change in Private Inventories nm* nm* nm* -0.46 0.73 -1.27
D.  Net Exports nm* nm* nm* 0.23 0.38 -0.25
E.  Government -0.7 3.9 -6.6 -0.14 0.75 -1.33
Memo:  Final Sales 1.7 2.4 1.1 1.71 2.37 1.13
    nm* = not meaningful
$ Value of Change in Private Inventories (2005 prices) $41.4b $60.3b $20.0b

The Bureau of Economic Analysis of the US Department of Commerce released on January 30 its initial estimate (what it formally calls its “advance” estimate) of US GDP growth in the fourth quarter of 2012.  The result was terrible:  GDP is estimated to have declined by a slight amount (0.1% at an annual rate).  While it is possible that this estimate will be revised upwards as the second and third revisions are released next month and the month after (there has historically been an upward revision on average of 0.3% points from the advance estimate to the third, and there was a particularly large upward revision in the 2012Q3 figures between the advance and third estimates), fourth quarter growth will still likely be disappointingly low.

The primary cause of the stagnation of GDP in the fourth quarter was a sharp cut in government spending.  As shown in the table above, total government spending on goods and services (federal, state, and local) fell at an annualized 6.6% rate in the quarter.  This had the direct impact of subtracting 1.33% points from what GDP growth would otherwise have been.  But there will also be an indirect impact, as workers who would have been employed producing goods and services for government would in turn buy goods and services themselves with the salaries they would have received.  With a multiplier of just two, the impact of the cut in government spending in the fourth quarter was a subtraction of 2.66% points (2 x 1.33% points) from what growth would have been.

Most of the decline in government spending was due to a large fall in spending at the federal level, although state and local spending fell some as well.  Federal government spending fell at an annualized rate of 15%, all due to a fall in defense spending at an annualized rate of 22%.  These declines more than offset increases of an estimated 9.5% and 13% in total federal and in defense spending respectively in the third quarter, which had contributed to the relatively good GDP growth of 3.1% in that quarter.  The swings were likely due to end of the fiscal year spending (the federal fiscal year ends September 30) which was particularly sharp last year and therefore not picked up in the normal seasonal adjustment calculations.  The fall in the fourth quarter of 2012 (the first quarter of the fiscal year) reflected the continued budget uncertainty, as Congress threatens to slash the current budget drastically, either by design or through the automatic sequester cut-backs dictated as part of the agreement to get out of the debt ceiling debacle in 2011, that might be instituted soon (see below).

The fall in government spending in the fourth quarter was particularly sharp, but government spending has been falling in each quarter but two since the beginning of 2010.  The resulting fiscal drag has held back growth.  The figures are shown in the graph at the top of this blog.  The graph shows the rate of growth of GDP each quarter (in blue, at annualized rates) since the beginning of 2007, plus the direct contribution to this growth each quarter from government expenditures (in red).

Government spending rose each quarter in 2007 and 2008, the last two years of the Bush Administration, and this continued into 2009 after Obama was inaugurated.  The growth in government expenditures was particularly sharp in the second quarter of 2009 as the stimulus measures started, and this succeeded in turning around GDP.  GDP was falling at an annualized rate of 8.9% in the fourth quarter of 2008, and this carried over into the first quarter of 2009 with an annualized fall of 5.3%.  But then GDP stabilized and began to grow in the third quarter of 2009, and it has grown each quarter since until the fourth quarter of 2012.

But GDP growth since 2010 has been disappointingly modest, at rates of just 2 to 3% a year on average (with some quarterly fluctuation), as it has been dragged down by the falling government expenditures over this period.  As has been noted in earlier postings on this blog (for example here and here), the resulting fiscal drag can explain fully why this recovery has been modest in comparison to the recoveries seen in previous downturns in the US economy over the past four decades.

The other major factor explaining the stagnation of GDP in the fourth quarter was the negative contribution from inventory accumulation.  The change in private inventories led to 1.27% points being subtracted from what GDP growth otherwise would have been.  But as was explained in an Econ 101 posting on this blog, it is the change in the change in private inventory accumulation which acts to contribute to (or subtract from) GDP growth in any given period.

One sees news reports that still get this wrong, with statements such as that inventories fell by $40 billion in the fourth quarter.  This is not correct.  As noted in the table above, inventories actually grew by $20 billion in the fourth quarter.  But they grew by more (by $60 billion) in the third quarter.  That is, the change (the growth) in inventories was $60 billion in the third quarter, while the change (the growth) in inventories was again positive at $20 billion in the fourth quarter.  But while they continued to grow, they did not grow as fast as before, and the change in the change in inventories was a negative $40 billion.  This subtracted 1.27% points from GDP growth.

As was noted a year ago on this blog when the figures for GDP growth in the fourth quarter of 2011 were released, an increase in private inventory accumulation in that quarter largely explained the relatively good growth rate of that quarter.  But I argued this would then likely be reversed, with inventories not growing as fast and perhaps even declining, which would act as a drag on growth in 2012.  The 2012 figures now out show that this in fact happened, with a negative contribution of private inventory accumulation to GDP growth in the first, second, and fourth quarters.

Other than the drag from cuts in government spending and the deceleration of inventory accumulation, the other components of GDP growth in the fourth quarter of 2012 were generally quite good.  Residential fixed investment grew at an annualized rate of 15.3%, continuing the strong growth seen already in the second and third quarters.  But residential fixed investment was only 2.6% of GDP in the fourth quarter, so the rapid growth on this small base only made a contribution of 0.36% points to GDP growth in the quarter.  In contrast, government spending in the fourth quarter was 19.3% of GDP (down from 19.6% of GDP in the third quarter).  [Figures on GDP shares directly from BEA on-line GDP tables.]

Non-residential fixed investment (basically private business investment in capital and structures) also grew at a good rate in the fourth quarter, at 8.4% annualized, reversing a small decline seen in the third quarter.  And personal consumption expenditure rose at a 2.2% rate.  Since personal consumption accounts for 71% of GDP spending, this 2.2% increase contributed 1.52% points to what GDP growth would have been.

The fourth quarter GDP report therefore would have been solid, had it not been for the sharp cuts in government spending in the quarter.  Accumulation of private inventories then responds, as businesses do not want to see inventories mounting up on the shelves when they cannot be sold and scale back production (or in the fourth quarter, still increase their inventories, but not by as much as before).

The danger to the economy now is that government spending will be scaled back even further, as a Republican controlled Congress insists on slashing public expenditures.  If nothing is agreed to, then the sequesters that Congress required in August 2011 as a condition for the debt ceiling increase (so that the US would not then be forced to default) will mandate a sharp scaling back in federal government expenditures.  While the deadline for this was pushed back to March 1 from January 1 as part of the fiscal cliff agreement at the end of 2012, there is still a deadline.  The nonpartisan Center on Budget and Policy Priorities has estimated in a recent report that should the sequester enter into effect on March 1, defense spending would be cut by $42.7 billion, or 7.3%, while non-defense spending would be cut by also $42.7 billion, or 5.1% for programs included other than Medicare (Medicare would be cut by 2.0%).

Such cuts, especially if they suddenly enter into effect on March 1, would be devastating to  the economy.  Note that while federal spending already fell by 15% at an annualized rate in the fourth quarter, this fall at a quarterly rate is just 3.6%.  The sudden cuts under the sequester would be far larger.

Almost all of the participants in this budget process, both Democrat and Republican, agree that the sequester is something to be avoided.  The sequester requirement was in fact set up precisely as something both sides would want to avoid, so that agreement would be reached on some other budget plan.  But Republicans are insisting on similarly large cuts in any budget.  They simply wish that the cuts would fall more on domestic programs affecting the poor and middle classes, and less on the military.  But economically the problem for GDP growth would remain if similarly sized cuts are forced through, and would indeed be worse (in terms of the impact on GDP, even ignoring the distributional consequences) if they are re-focused on programs for the poor and middle classes.

Finally, it is worth noting that the price index figures also released by the BEA on January 30 as part of the GDP accounts still show no indication that inflation is any issue.  While conservatives have been asserting since Obama took office four years ago that high deficits resulting from his policies would lead to high inflation, that has not occurred.  The price deflator for GDP, the most broad-based index measuring inflation, grew by only 1.8% in 2012.  The price deflator for the personal consumption expenditures component of GDP (the price deflator that Alan Greenspan reportedly favored for tracking inflation) grew by a similar 1.7% in 2012.  These are both just below the target of 2% for inflation that the Federal Reserve Board favors.  (Inflation of zero is not desired by the Fed or others as it is then easy for the economy to slip into deflation, which makes management of the economy even more difficult.)

And inflation in the fourth quarter of 2012 was even less, at just 0.6% for the GDP deflator and 1.2% for the personal consumption expenditures deflator.  The prediction of both conservative economists and politicians that high deficits under Obama would lead to high inflation unless government expenditures were slashed drastically, could not have been more wrong.

GDP Growth in the First Quarter of 2012: A Slow Economy Going Slower

BEA release of 4/27/12 2011 Q3 %growth 2011 Q4 %growth 2012 Q1 %growth Contribution to GDP growth in 2011 Q4 Contribution to GDP growth in 2012 Q1
Total GDP 1.8 3.0 2.2 3.0 2.2
A.  Personal Consumption Expenditure 1.7 2.1 2.9 1.47 2.04
B.  Gross Private Fixed Investment 13.0 6.3 1.4 0.78 0.18
   1.  Non-Residential Fixed Investment 15.7 5.2 -2.1 0.53 -0.22
   2.  Residential Fixed Investment 1.3 11.6 19.1 0.25 0.40
C.  Change in Private Inventories nm* nm* nm* 1.81 0.59
D.  Net Exports nm* nm* nm* -0.26 -0.01
E.  Government -0.1 -4.2 -3.0 -0.84 -0.60
   1.  Federal Government 2.1 -6.9 -5.6 -0.58 -0.46
   2.  State and Local Government -1.6 -2.2 -1.2 -0.26 -0.14
Memo:  Final Sales 3.2 1.1 1.6 1.15 1.61
        nm* = not meaningful
$ Value of Change in Private Inventories (2005 prices) -$2.0b $52.2b $69.5b

A.  Introduction

The Bureau of Economic Analysis (BEA) of the Department of Commerce released this morning its first estimate of GDP growth in the first quarter of 2012.  The table above summarizes the key figures.  Overall, the report is disappointing.  Many observers were expecting GDP growth to accelerate, continuing the path of quarter by quarter increases seen during the course of 2011 (with growth rates of 0.4%, 1.3%, 1.8%, and 3.0%, in the first through the fourth quarters, respectively).  But readers of this blog may recall that I had warned of a real possibility of deceleration in a posting on January 27, when the BEA released its first estimate of growth in the fourth quarter of 2011.  That slowdown has happened.  So far the slowdown has been modest, and one should not put too much emphasis on one quarter’s figures.  But a deeper assessment of the numbers contained in the report suggests that growth could slow further in the next few quarters, in the period just before the Presidential election.  This is not good for Obama.

The table has a lot of numbers to give the full picture, but we will focus on a few.  The table is similar to the one I used in the January 27 posting noted above, although this time I have split out the Change in Private Inventories from other investment (i.e. from Fixed Investment), to give a clearer picture of the trends.  Note also that the figures for the fourth quarter of 2011 differ somewhat from those shown in the January 27 posting.  This is because the January figures were the initial estimates (the BEA calls them the “advance estimates”), which are then revised twice (and released in late February and then in late March).  The initial estimate for the fourth quarter of 2011 was that GDP rose by 2.8%.  Following the revised second and then third estimates (as more complete data became available), the GDP growth rate for the period is now estimated to have been 3.0%.  And there are small changes in a number of the other figures as well.  Similarly, the release today was the initial estimate for the first quarter of 2012, and revised estimates will be released in late May and then in late June, before the release in late July of the initial estimates for the second quarter.

B.  The Change in the Change in Private Inventories

It is best first to focus on what has happened to the Change in Private Inventories, as this can drive the short term dynamics of quarter to quarter GDP growth.  As was described in a posting in the Econ 101 section of this blog, it is the change in the change in private inventories which leads to a change in GDP (i.e. to GDP growth).  In the last line of the table above, I have shown what the actual (estimated) dollar value was of inventory accumulation (the change in private inventories), going back to the third quarter of 2011.  In that third quarter, the stock of inventories in fact fell a small amount, by $2.0 billion (in 2005 prices).  Inventories are then estimated to have grown by $52.2 billion in the fourth quarter, for a change in the change in private inventories of $54.4 billion.  This contributed 1.81% points of the 3.0% growth in GDP.  That is, fully 60% ( = 1.81 / 3.0 ) of the growth in the fourth quarter (based on the revised figures) is now estimated to have come from inventory accumulation.

In the first quarter of 2012, private inventories are estimated to have grown by even more than they did in the fourth quarter:  by $69.5 billion.  But even though inventory accumulation is now estimated to have been higher, the change in the change in inventories was only $17.3 billion ( = $69.5b – $52.2b).  Thus even though inventory accumulation was greater than in the fourth quarter of 2011, the contribution to the growth of GDP in the first quarter of 2012 was an estimated 0.59% points (vs. the 1.81% of the previous quarter) of the 2.2% growth, or about 27% ( = 0.59 / 2.2 ) of the growth in GDP.

Inventory accumulation thus continued to add to, rather than subtract from, overall GDP growth in the first quarter, but at a slower pace than in the fourth quarter.  Looking forward, inventory accumulation would need to grow further to $86.8 billion ( = $69.5b + $17.3b) for the change in the change in private inventories to continue at the same pace, and contribute approximately 0.6% points to growth.

But with high positive inventory growth for two quarters now, there is a good chance that producers will cut back on production so as not to add so much to inventories sitting on shelves.  If inventory accumulation even simply continues at the $69.5 billion pace of the first quarter, the change in the change in inventories will then be zero.  If all else in the economy continues to grow as it did in the first quarter (it won’t, but if it did), then the growth rate in the second quarter would be 2.2% – 0.6% points = 1.6% (which is the rate of final sales growth in the quarter; see the table above).

But inventory accumulation could be a good deal less than that.  A fall in the stock of inventories is not unusual.  From 2001Q1 through 2012Q1, for example (a period of 45 quarters), the change in private inventories was negative in 15 of the quarters (i.e. one-third of the time) and positive in 30.  Even if the change in private inventories was just zero, and not even negative, the change in the change in private inventories would then be a negative $69.5 billion from the pace in the first quarter.  This would subtract 2.4% points from GDP growth, and if all else grew at the pace it did in the first quarter, then GDP growth would be a negative 0.8% ( = 1.6% growth of final sales minus the 2.4% points).

There is a good chance, but no certainty, the pace of inventory accumulation will slow down.  If so, overall GDP growth would slow, and even possibly turn negative.  The economy remains weak.

C.  Personal Consumption and Fixed Investment

A positive in the figures is that household expenditures, for both personal consumption and for residential investment, continued to strengthen.  Personal consumption (which accounts for 71% of GDP), grew by 2.9% and accounted for 2.04% points of the 2.2% growth.  And residential fixed investment (mainly housing) grew at a very fast 19.1% pace, following the 11.6% growth of the fourth quarter.  These are strong figures, and suggest housing may be starting to recover.  However, as had been noted in the January 27 blog posting, residential fixed investment has fallen by so much in the crash of the housing bubble (to just 2.3% of GDP now, from a high of over 6% during the bubble, and a more normal 4% of GDP or so), that such investment would need to double to return to normal levels, or triple to get back to where it was before.  And with its current small share of GDP, the 19.1% growth of residential fixed investment only accounted for 0.40% points of the 2.2% GDP growth in the first quarter.

Offsetting this positive news on household consumption and investment, there was a decline in business (i.e. non-residential) fixed investment.  Business fixed investment had been strong earlier in the recovery, from early 2010 through to late 2011, but is estimated to have contracted by 2.1% in the first quarter.  This subtracted from GDP growth.  And with business fixed investment (at 10.3% of GDP currently) much larger than residential fixed investment, the declining growth of business fixed investment has pulled down overall fixed investment from a 13.0% rate of growth in the third quarter of 2011, to 6.3% in the fourth quarter, and to just 1.4% in the first quarter.

D.  Fiscal Drag Continues

Finally, and most stupidly in a still depressed economy with high unemployment, government expenditures are falling, acting as a drag bringing down the overall economy.  And while earlier this fiscal drag was mostly due to cuts in government expenditures at the state and local level, cuts in federal expenditures are now also pulling down the economy. Federal government expenditures on goods and services fell by 5.6% in the first quarter, following a fall now estimated at 6.9% in the fourth quarter.  State and local government expenditures continued to fall (as they have in 11 of the 13 quarters since the first quarter of 2009), but now federal expenditures are falling even faster.

The direct impact of the decline in government expenditures subtracted 0.6% points from what growth would otherwise have been in the first quarter.  That is, had government expenditures simply remained flat rather than fallen by 3.0% (for federal combined with state and local), GDP growth would have been 2.2% + 0.6% = 2.8%.  With a modest 3.0% growth (instead of a 3.0% cut) in government expenditures, growth in the first quarter would have been a more respectable 2.2% + 1.2% = 3.4%.  And assuming a multiplier of just 1.5, the growth rate would have been 2.2% + 1.5×1.2% = 4.0%.  While still modest, this would bring GDP growth closer to the rate needed for a sustained reduction in unemployment.  And as was noted in a previous posting on this blog, had government expenditures been allowed to grow at the pace it had during the economic downturn after 1981 during the Reagan years, the economy would now be at full employment.

Cutting government expenditures when the economy is so weak and unemployment so high only serves to further weaken the economy.  The consequences of an even more severe austerity program can be seen in the UK.  The Conservative Government in the UK has adopted an austerity program similar to what Republicans have pushed to be adopted here.  The new GDP report for the UK issued two days ago indicates that growth in the UK was negative in the first quarter of 2012, as it was in the fourth quarter of 2011.  The two quarters of negative growth meets the criterion normally used to define a recession, and hence the UK has now dropped back into recession for the second time since the 2008 crisis.

The US has fortunately not adopted an austerity program as severe as that adopted by the UK.  However, Republicans are pushing strongly for the US to do so.  If Obama did, the results would be similar to that seen in the UK.  If you are running for re-election, that is not a good place to be.  And that may explain why the Republicans have been pushing for it.