As Inventories Rise . . .
. . . so will jobs and the economy.


David Malpass

Many financial markets have begun to reflect the economy’s move from deflation to reflation. However, the economic strength of the reflation process is still being underestimated. Businesses are rebuilding inventories, which will cause industrial production to accelerate, capacity utilization to rise, and employment to grow. This should raise economic growth expectations from “moderate” to “fast.” And at some point along the way, the Federal Reserve will signal that it’s going to hike rates, and then it will carry out those hikes — lifting the fed funds interest rate to 3 percent (it’s now at 1 percent) sooner than the market now expects.

No one knows very much about deflation or reflation. The U.S. has never gone through either state while under a floating exchange-rate regime. And the U.S. broke away from the only other occurrence — Japan’s deflation experience of the 1990s — with the Fed’s quantitative easing after 9/11, the dollar’s 2002 reversion to a non-deflationary level, and the president’s strongly stimulative tax cut this year.

Though it is popular to blame China for U.S. job losses, the data shows clearly that the ongoing U.S. inventory reduction — a vestige of deflation and a sign of risk aversion – drove the weakness in manufacturing, capacity utilization, and manufacturing jobs. As inventories rise, the perception of the U.S. economy and its competitiveness should improve quickly.

A number of indicators will soon begin to show (and are already starting to show) the extent of the reflationary acceleration of the U.S. economy, pushing growth estimates above 5 percent, from below 4 percent. Gold prices have already risen. Commodity prices are catching up. Equities and bond yields have risen. And the risk spread (or difference) between Treasury bills and corporate bonds has narrowed.

Consumer demand in July and August accelerated from the strong 4 percent annualized second-quarter growth rate. Retail sales for August were “below expectations” only because a small sample of auto receipts reported slow growth in early August. The more solid piece of data — the actual number of autos sold as reported by the auto companies — was up 9.6 percent in August. This is the measure used in calculating third-quarter gross domestic product. Retail sales excluding gasoline grew 13 percent at an annual rate in the last six months.

The drawdown in inventories has been part of the drag on manufacturing production. With demand growing strongly, inventories will rebuild, causing manufacturing production to grow. And this increase in manufacturing production will soon contribute to employment gains. The loss of manufacturing jobs since the February 2001 employment peak accounted for almost all the total job losses, making manufacturing jobs a key variable in near-term job growth.

The concerns currently expressed in the financial markets — and also at the Fed — over a jobless recovery and excess capacity seem misplaced and could evaporate quickly as inventory rebuilding kicks in.