Taking Inventory of Our Supply Chain Problems

Posted by Vident Financial on 1/13/22 9:43 AM

Continuing our series about supply chain disruptions, we now look at business inventories, because basically they are what supply chain problems are all about: not enough stuff on the shelves, in the back, or in the warehouse. There are other reasons shortages can occur. A common historical cause is when price controls induce vendors to hold goods rather than sell them at a loss. But that sort of thing doesn't tend to happen in capitalist economies where prices are set by markets, like that of the U.S. When demand outstrips supply, it mostly reflects itself as price increases, not supply shortages. Those price increases signal producers to produce more, which helps end the shortages. We can see that in the data below, which represents the monthly percent change in business inventories:

(Source: FRED, December 2015 – September 2021)

We see decreases in inventory starting in late 2019, perhaps reflecting disruptions due to early waves of COVID-19 before it captured headline attention. Inventories collapsed dramatically as the pandemic lockdowns came into force. Then things switched around mid-year and businesses began to rebuild inventory. Inventory changes since then have been positive but uneven, with the lowest increases occurring in April.

This data tells us some things, like the volatility that happens in inventory under the off-and-on-and-off-again pandemic rules. But it leaves something important out: The demand for inventory. In other words, it does not tell us how large inventory supply is relative to inventory demand.

For example, the huge decreases in inventory in March, April and May of last year look very dramatic. But they don't tell you how much sales went down during the same period. If we look at the ratio of inventory to sales, we see not just how much business is adding to (or subtracting from) what it has on-hand to sell, but also how much margin it has to meet current demand. We can see that data below:

Business Inventory to Business Sales Ratio

(Source: FRED, 1-1-2016 to 9-1-2021)

Adding sales to the equation adds a helpful dimension. We see here that although inventory was falling fast during the shutdowns last spring, sales were falling much faster, and so businesses were actually building up the capacity to serve customers. Business made the bet that the consumer would come back. That's why we had the very unusual situation we described last fall ("What This New Economic CAT Scan Shows About This Recession," Vident Financial blog, 10-13-20) in which Gross Output (the whole economy) was collapsing less than Gross Domestic Product (mainly the consumption part of the economy). When the whole economy collapses but consumption collapses more, inventory spikes, which it clearly did last spring as shown in the chart above. Then as the economy stumbled into recovery, sales rose faster than inventory, which means that the Inventory/Sales ratio dropped rapidly last year as goods flew off shelves, and shelves were restocked from backrooms, and backrooms were refilled from warehouses. Early this year that margin, the capacity to serve consumer demand, collapsed to very low levels compared to available history. That's the origin of the supply chain problems we are hearing so much about now. But also, please note that things started to improve in August and September. In other words, business managers saw the problem and started to address it.

Does that mean we're out of the woods? Probably not. Human nature is such that once we catch the whiff of fear about shortages, we buy more in order to get ours first. We saw that with the Great Toilet Paper Panic of 2020: People bought toilet paper because other people bought toilet paper. Of course, all that meant is that we shifted the inventory management function out of the stores and into our garages and basements. The world never did run out of toilet paper.

Panic triggers buying and hoarding. Buying and hoarding create empty shelves. Empty shelves create more panic. But business is agile and adjusts accordingly, though it might take a little time.

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