3:18 pm
Tue November 11, 2003

Double Good News

In this tenuous time of economic recovery, commentator Dennis Henderson says there is double-good news to report.

Wilmington NC – Click the LISTEN button above to hear Dennis' commentary.

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Bullish reports on economic growth during the third quarter contained some particularly good news for manufacturing ? which has suffered more than any other sector from the sluggish economy since the turn of the decade. But, robust economic growth during the summer is only part of the good news. Trends in commodity prices and interest rates account for more of the story. Let me explain.

The third quarter?s 7.2 percent annual rate growth in GDP, or gross domestic product, was paced by a 7.8 percent increase in final sales of goods and services. The relevant point here is that the rate of gain in sales out-paced the overall increase in output. This means that inventories of unsold goods declined. Commerce Department reports confirm a decline in business inventories, with factory inventories now at their lowest level since September 1997.

As an aside, this helps explain seemingly-inconsistent trends in production and employment, or why employment has been slow to respond to the brisk up-turn in final sales. The difference being, in part, that some of the increase in sales came out of inventories, rather than from new, job-creating production.

Manufacturers are now in the position of facing relatively strong growth in demand for their products, and smaller inventories of unsold goods. This suggests that they are likely begin to rebuild inventories in order to have adequate supplies of manufactured goods to meet any continued growth in sales. This is clearly the good news from the third quarter GDP and sales data, and points toward new jobs.

Now for the second part of the good news story. After holding relatively steady for quite some time, prices are now rising for industrial commodities ? output from factories and mines, and the things manufacturers need to make their products. Since mid-August, the index of industrial commodity prices has increased at an annual rate of nearly 25 percent. This can significantly influence manufacturers inventory behavior. When prices are relatively flat, there is little incentive to acquire inventories as next-month?s supply may be purchased at even a lower price. But, when prices are rising, a ?buy now? strategy makes sense. That is, accumulate inventories.

The ?rising price? incentive to accumulate inventories is also affected by the cost of holding inventories. A significant part of the cost of holding inventory is, interest on the money invested. With short-term interest rates at a 45-year low, holding costs are also low.

The extent to which the ?buy now? strategy will be implemented is affected by expectations regarding future trends in commodity prices. It seems likely that they will continue to trend upward, for two reasons. First, the US dollar price of commodities tends to be inversely related to the value of the dollar ? when the dollar is low, as it is now, traders can make riskless profit by buying commodities for dollars and reselling them abroad for higher-value currencies such as the euro or yen. This bids-up the dollar price of the commodities.

Second, commodity prices are likely to rise because of broadening activity in global manufacturing. The Asian manufacturing giant, China, is barreling along, pulling with it other Asian economies such as South Korea, Thailand, Taiwan, and even Japan. There also appear to be gains in Europe, with recent purchasing-manager indices up in both the UK and the euro zone.

In sum, the US manufacturing sector appears to be in for a double-strength boost. Because inventories are low, new orders have to be met from new production. Because commodity prices are rising relative to holding costs, economic incentives exist to rebuild inventories. This spells expansion in industrial output, which ultimately points to more jobs and larger payrolls ? exactly the medicine our long-struggling factories and mines need at this point in our still-tenuous economic recovery.


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An archive of transcripts of Dennis Henderson's commentaries can be found at whqr.org/Dennis%20Henderson/archive03.htm.