Money Supply
Though money supply measures were long ago relegated to the bottom of the Fed's list of policy tools, they are still useful in providing clues regarding the strength of the economy and they are still watched by the Fed - albeit to a limited extent. Here's a refresher on just what the monetary aggregates are - how they are constructed, why they matter, and how much the Fed cares about each. Let's start with the strict definitions.
M1, the narrowest of the monetary aggregates, contains the following:
Currency, except that held by the Fed, Treasury, or banks/thrifts
Travelers checks
Demand deposits (non-interest bearing checking accounts), except those due to banks, the government, or foreign institutions
Other checkable deposits - most notably NOW (negotiable order of withdrawal) accounts
M2, the aggregate which the Fed watches most closely, contains the following:
M1
Savings deposits (including money market deposit accounts- MMDAs)
Time deposits (known commonly as CDs or certificates of deposit) in denominations of less than $100,000
Balances in retail money market funds (retail funds have minimum initial investments of less than $50,000)
Finally, M3 - the broadest aggregate - contains:
M2
Time deposits in denominations of $100,000 or more
Balances in institutional money market funds (minimum investments of more than $50,000)
Overnight and term repurchase agreements
Overnight and term eurodollars held by U.S. residents
The Decline of M1
In the early 1980s, M1 was directly targetted by the Federal Reserve, and its weekly release was of critical importance to the financial markets. Today, M1 is barely noticed, and its stock continues to decline. The reason for M1's demise as a useful indicator is financial deregulation, which enabled individuals to hold transaction balances in accounts such as MMDAs which were not included in M1. More recently, M1 has lost what little usefulness it had left as sweep accounts have undermined the narrow aggregate.
Sweeps-stakes
Sweep accounts are a hybrid checking account/savings account. In a typical sweep account, banks will sweep part of a NOW account's balance into an MMDA. As funds are needed to cover checks written against the NOW account, the bank will periodically shift funds from the MMDA back into the NOW account. Since the legal maximum number of withdrawals from an MMDA is six per month, all funds will be shifted back to the NOW account on the sixth transaction of the month.
Sweep accounts benefit both banks and depositors. Banks benefit because MMDAs do not require any reserves to be held with the Fed, while NOW accounts are reservable. As these required reserves are non-interest bearing, banks benefit by reducing their level of required reserves. Depositors benefit because MMDAs carry higher interest rates, and thus earnings on checking balances are increased.
Over the past two years, the popularity of sweep accounts has exploded. In January 1994, the Fed estimates that only $5 bln in deposits were covered by sweep accounts. By December 1996, this total had ballooned to $171 bln. As NOW accounts are in M1 and MMDAs are in M2, M1 has been dramatically weakened by sweeps, while M2 has not been affected (since M2 already includes M1, a shift from a NOW account to an MMDA has no impact on M2).
The Rise and Fall and Rise of M2
Without question, M2 is now the most closely watched monetary aggregate - both by economists and the Federal Reserve. The 1978 Humphrey-Hawkins Act mandated that the Fed set annual targets for money supply and that the Fed Chairman report to Congress twice each year regarding these targets. The Fed used to take that responsibility quite seriously - setting point targets for M1 growth. Now, the Fed sets only target ranges for M2 and M3. Even these ranges are something of a joke - if the Fed misses the target range, it tends to move the range rather than try to get M2 and M3 back within the range. Nevertheless, the M2 target is the one which the Fed takes most seriously and which the market watches most closely.
The reduced emphasis on M2 first became evident in the late 1980s but was sealed in the early 1990s. M2 is a useful indicator only so long as its velocity (the rate of turnover of a dollar of M2, or mathematically, nominal GDP divided by M2) is stable over the long term. Unfortunately, the long term stability of M2 velocity, which was at the core of monetarism, disappeared beginning in the late 1980s. Banks and thrifts, devastated by nonperforming assets, pulled back from their traditional lending business, with market financing sources picking up the slack. The result was a break from the long term trend in M2 velocity. Suddenly, one dollar of M2 could fund far more nominal GDP growth, as market financing increased the efficiency of the financial system.
Regardless of the hows and whys - which are still debated by economists - the bottom line was that M2 was no longer a reliable indicator. More recently, however, M2 has exhibited a more normal relationship with nominal GDP. This renewed predictability in M2 velocity has lasted roughly two years - enough to entice policy makers to keep an eye on M2 again, but not enough for them to trust it.
It will take many years of predictable velocity before the Fed once again places much emphasis on M2 in its policy deliberations. And it is safe to say that neither M2 nor any other monetary aggregate will occupy the top spot in policy making as M1 did in the early 1980s. The record of interest rate targetting has simply been much better than that of money targetting.
M3: Still Bringing Up the Rear
M3 attracts more attention than it did previously, due largely to the demise of M1, but its inclusion of institutional accounts makes it less attractive than M2, which focusses on individual deposit accounts. The bottom line in determining which aggregate receives the most attention is the relative stability of its velocity. Even though M2 velocity went off course in the early 1990s, it has still been the most predictable of the three during the postwar period. |
