Inventory and inventory carrying costs both set to rise

Jim Haughey, Director of economics for Reed Business Information -- Industrial Distribution, 8/22/2005

Industrial distributors have just entered the accumulation phase of the inventory cycle.  Inventories will be rising faster than sales into the winter, which will push up the cost of carrying inventory. As always, there is a risk of seeing customer orders as consumption demand rather than inventory restocking, resulting in a period of significant excess inventory at the top of the cycle.

The inventory cycle is one of several contained within the long business expansion period from spring 2003 into 2007. Industrial distribution inventories, measured in dollars, expanded 3.3 percent in the first half of 2005. However, the physical amount of inventory shrunk 0.5 percent because prices for durable manufacturing supplies, materials and components rose 3.8 percent. The inventory reduction early this year followed a period of accumulation in the second half of last year when inventories, after inflation, increased 2 percent.

Inventory cycles have been shortened by improved sales and stock management so that inventory adjustments take place over shorter periods of time. This makes the inventory cycle seem more extreme, although the total amount of inventory change over a full cycle is now less than previous cycles. Across the entire economy, the recent inventory drawdown knocked 2.3 percentage points off GDP growth in the spring quarter. The projected accumulation will add about 2 percent to GDP growth in the summer quarter, and as much as 1 percent in the fourth quarter of 2005.

Inventory accumulations this late in a business expansion are usually rather modest. But the current restocking period is likely to be very robust, matching the expected return of overall economic growth to 4.5 percent after dropping to 3.5 percent to 4.0 percent for most of the last year. Much of the added growth will be in industrial distribution end markets. This includes a post-inventory rebalancing pickup in manufacturing production. Also, motor vehicle production schedules will be higher after deep discounting in July and August drove dealer inventories to near the minimum operating level. Some distributors will feel the impact of a forecast 16 percent (10 percent-plus after inflation) jump in non-residential construction spending through the end of next year, after four years of negligible growth.

Strong economic growth always raises distributor operating costs. Over the first 10 quarters of above-average growth, the cost pressures were largely absorbed by the slack in the economy that developed in the last recession. Very little slack is now left. The unemployment rate has fallen to 5 percent, and the industrial capacity utilization rate has risen to 80 percent. These are both thresholds beyond which cost pressures can no longer be absorbed. Inventory carrying costs are beginning to rise, and the increase will accelerate into 2007. 

The financial cost of holding inventory will increase the most. The benchmark short-term interest rate for the 90-day Treasury Bill was 3.4 percent in mid-August and will increase to near 5 percent by late next year. Inbound freight costs increased about 8 percent in the past year with a gain almost as large likely over the next year, even if crude oil prices retreat from $65/bbl. Less than truckload, and especially truckload, freight rates have been adjusted to only about $50/bbl. by early August. Freight rates will also be rising because carriers raise their margins when freight capacity is strained.

High point: Sept 2000

Low point: June 2004

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