Still cautious about the economy, businesses continue to reduce excess inventory, as they cut costs and re-align their operations with consumer demand.

Business inventories fell 1.0 percent in July, the U.S. Commerce Department announced Tuesday, led by a decline in retail and manufacturing inventories.

Economists surveyed
by Bloomberg News had expected inventories to decline 0.9 percent in July. Inventories fell a revised 1.4 percent in June; they fell 1.0 percent in May and 1.3 in April. What's more, inventories have fallen 11.8 percent in the past year, and have declined for 11 straight months. Retail inventories are now 10.7 percent lower than a year ago; manufacturing inventories, 8.5 percent lower.

Meanwhile, sales rose 0.1 percent in July, after rising 0.9 percent in June, and dipping 0.1 percent in May. Sales have declined 17.8 percent in the past 12 months.

Are businesses adjusting to new era?

Further, the inventory-to-sales ratio declined again -- a statistic that reflects both typical, cyclical caution that one normally sees during economic troughs, and most likely an awareness by businesses that consumer spending may not return to previous growth rates, due to the "frugal consumer" era. The ratio, an indicator of demand, fell to 1.36 in July from to 1.38 in June; the ratio was at 1.42 in May and 1.43 in April. A year ago, the ratio was 1.27.

In general, economists prefer to see business inventories decline during a recession, as it historically indicates that businesses are bringing inventories back in line with reduced demand, taking excess supply out of the system. That draw-down has set the stage for both production increases and at least modest hiring, once the economic recovery starts.

Further, the decline in retail inventories in July is consistent with structural changes in the nation's retail sector. Americans have decreased their discretionary purchases after a decade of unsustainable, debt-fueled overconsumption. And retailers are taking no chances risking the stockpiling of product they may not sell in a normal time frame.

Economic Analysis: Once again in July, companies did their best to reduce inventories, and if historical business and inventory cycles are any indicator, manufacturers should start to increase production in Q3. Add a modest increase in both consumer spending and business investment, housing sector stabilization, and a slight tailwind from exports, and GDP will likely turn positive in Q3.

Of course, the big wild card moving forward is consumer spending: there's no guarantee that producers will receive modest support from the new "frugal consumer," but given the length of the recession, and the other components of demand, the argument is tipped in favor of an economic recovery in the second half of 2009.


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