May U.S. business inventories fall sharply

U.S. businesses continue to reduce excess inventory, amid weak demand.

Business inventories fell 1.0 percent in June, the U.S. Commerce Department announced Tuesday, led by a plunge in auto inventories.

Economists surveyed by Bloomberg News had expected inventories to decline 0.8 percent in June. Inventories fell 1.1 percent in April. What's more, inventories have now fallen 8.0 percent in the past year, and have declined for nine straight months.

Meanwhile, sales dipped 0.1 percent in May and are down 17.8 percent in the past 12 months.

With inventories falling faster than sales, the inventory-to-sales ratio declined again. The ratio, an indicator of demand, fell to 1.42 in May from 1.43 in April. The ratio was at 1.28 a year ago.

Economy emerging from recession?

Economists expect the inventories declines to slow in the second half of 2008, as manufacturers ramp up production to restock shelves -- a business cycle phase that usually boosts GDP. Dean Maki, chief U.S. economist for Barclays Capital (BCS) in New York, is in that camp.

"Inventory declines -- especially in autos, but also in other manufacturing sectors -- have been so severe in the second quarter, the production simply has to start catching up to sales," Maki told Bloomberg News Tuesday. "As production improves, household wage and salary income also begins to improve," leading to a "self-sustaining" economic recovery. "We do think it is the end of the recession in the third quarter" with a quarterly growth rate of 2.5 percent expected, Maki added.

In general, economists prefer to see business inventories decline during a recession, as it has historically indicated that businesses are bringing inventories back in-line with reduced demand, taking excess supply out of the system. That drawdown usually sets the stage for both production increases and some job additions, once the economic recovery starts.

Economic Analysis: Again in June, companies did their best to reduce inventories, and if historical business and inventory cycles are any indicator, manufacturers should start to increase production about now. As noted, that fact, combined with a modest increase in both consumer and business demand, points to GDP growth in Q3. Of course, there's no guarantee that producers will receive modest support from the new "frugal consumer," but given the length of the recession, the inventory decline length, and the amount of delayed consumer purchases, the argument is tipped in favor of an economic recovery in the second half of 2009.

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