An energy price crisis, the threat of blackouts during winter, and a land war on European soil – 2022 has brought back many events that we thought we had left behind decades ago. The economic story of the year has without a doubt been the sharp uptick in inflation. Initially driven by higher energy prices, inflation has spread to a range of goods and services, causing the biggest drop in living standards in 40 years. However, going unnoticed by most, another economic trend has made a comeback in 2022 – the return of the inventory cycle.
The change in inventories, covering the stock of finished products, works in progress, and inputs, rose from a mere £1.3 billion in Q4 2021 to a staggering £16.1 billion in Q1 2022 before edging higher still to £16.5 billion in the following quarter.1 This compares to a long-run average of £505 million and equates to a reading 4.6 standard deviations above the mean.
What’s behind this massive build-up? One theory explaining the shift to higher inventories is that businesses’ experience of supply chain disruptions and sky-high shipping costs during the pandemic has caused a rethink in logistics operations. This shift, which has been dubbed a move from ‘just-in-time’ to ‘just-in-case’ procurement, means that businesses are happy to hold larger inventories as a form of insurance in an increasingly uncertain world. In the case of the UK, 2022 also brought about the introduction of customs checks on goods coming from and going to the European Union, making trade costlier and delivery times less predictable. Another theory states that the increase in inventories is the result of the so-called bullwhip effect. The economic fall-out of the pandemic has meant that a substantial number of households with excess savings tried to buy consumer goods at a time when international supply chains couldn’t keep up with demand. The bullwhip-effect explains how small(ish) changes at the retail level propagate through the economy, leading to large swings in production volumes as firms at every stage in the upstream supply chain try to get ahead of customer demand.
Regardless of the specific cause of the recent stockpiling frenzy, the implications for the wider UK economy will be substantial once firms start to run their inventories down. The contribution of inventories to GDP growth is determined by the rate of change rather than levels, so even if firms were only to slow down the build up in inventories, this would have a negative effect on GDP growth. If firms started to actively reduce the size of their inventories, the drag on growth would be even more severe.
Looking at the four-quarter rolling average, inventory build-up as a share of GDP has risen to 1.6% in the second quarter of this year. The only times in history when inventories reached a similar level were in 1989 and in the late 1970s. In both instances a deep recession followed as businesses ran down their stockpiles.
So, how big could the effect be this time?
The main determinant of this will be the speed with which businesses destock. An extreme example would be where businesses run their stocks down as quickly in the second half of the year as they built them up in the first. The hit to GDP compared to our baseline forecast would be 2.1% of GDP or around £46 billion. A more realistic scenario, based on historic data, would be to assume that the destocking cycle takes around two years to fully unravel. On this basis, we estimate that the UK economy will by 0.8% smaller by the end of 2024, a hit of around £17 billion, compared to a scenario where inventories had been flat between 2022 and 2024. Of course, there is a chance that past experiences are not an accurate guide for the current situation. In particular, if businesses are happy to permanently hold higher stocks of inventory, the above figures will be smaller. Still, it is difficult to imagine that businesses will be able to afford huge stockpiles of inputs and finished goods in times of rising financing costs. Given the economic backdrop of weaker consumer demand and a potential correction in the housing market, the return of the inventory cycle comes at the least opportune moment for the UK economy and further raises chances of a severe recession in 2022/23. The fact that businesses will likely need to discount their goods to clear stocks, and thereby help to reduce inflation, will be only a small consolation.
Annual GDP growth and change in inventories as share of GDP (rolling four quarter average)
1 All figures in real terms unless otherwise stated
For more information please contact:
Kay Neufeld, Head of Forecasting and Thought Leadership Email kneufeld@cebr.com Phone 020 7324 2841
Cebr is an independent London-based economic consultancy specialising in economic impact assessment, macroeconomic forecasting and thought leadership. For more information on this report, or if you are interested in commissioning research with Cebr, please contact us using our enquiries page.