Keep an Eye on the Money Supply
Tuesday May 08 06:15 PM EDT
SmartMoney.com
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<<TWENTY YEARS AGO, disco died, the space shuttle blasted off for the first time and economists pored obsessively over a group of money-supply statistics for clues as to how the economy would perform in the future.
For those of you who were too young to remember or too preoccupied with ``Dallas'' to care, the money supply became all the rage after the Federal Reserve (news - web sites)'s equivalent of a policy revolution. To beat back the soaring inflation that had ravaged the economy for most of the ``Me Decade,'' the Paul Volcker-led Fed dramatically changed its orientation from interest rate manipulation to money-supply massaging in 1979. And since Fed watching was every bit as popular among the Wall Street crowd back then as it is now, economists ate, slept and breathed mysterious money-supply statistics like M1 and M2.
But a few developments in the 1980s caused the Fed to reverse course. As a consequence of the sharp reduction in money-supply growth, interest rates moved dramatically higher, pushing the economy over the edge. The two nasty recessions that followed (one from January to July 1980, the other from July 1981 to November 1982), combined with plummeting energy prices, lessened inflation fears. Moreover, the rapidly increasing sophistication of the U.S. financial system made the money supply bewilderingly difficult to track. In the fall of 1982, the Fed abandoned what had become known as ``monetarism,'' choosing instead to tinker with the economy via the federal-funds rate, just as the central bank had done for decades before the inflation express began gathering steam.
Well, don't look now, but money-supply gazing is starting to make a comeback. No, inflation hasn't shot skyward and Alan Greenspan (news - web sites) hasn't jettisoned his cherished interest-rate-policy mechanisms. But the study of the money supply, in all its complexity, is back in vogue among a growing — and increasingly vociferous — group of economists.
``Does money matter?'' asks John Lonski, an economist at Moody's Investors Service. ``Yes, I think it does.'' Concurs Jim Angel, associate professor at Georgetown University's McDonough School of Business: ``Regardless of how you calculate it, [the money supply] has a huge impact on the economy.''
These economists, whom we'll call ``neomonetarists'' for lack of a better term, are far less hawkish than their intellectual forbears. They don't believe the Fed should fixate solely on the money supply, à la Volcker, whose aggressive money-supply restrictions killed inflation only at the expense of economic growth. But they do make the case that the money supply is far more important than most economists are willing to acknowledge these days — and they think the Fed should be looking at it more closely when making policy decisions. The money supply, they say, is the main determinant of economic growth in the short term and price movement over the longer term. When it's growing, the economy is expanding or is about to expand; when it's shrinking, the economy is headed for trouble.
The good news for investors: Right now, the neomonetarists like what they see. The money supply has spiked dramatically this year, and this, they say, augurs well for a quick economic recovery. While there are several money-supply measures, the most closely tracked figure is M2, a measure of all the cash and checking deposits held by the public (the most liquid forms of money, known as M1) plus savings and money-market funds. In the 12 months ending in March, M2 rose at an 8.1% annual rate, compared with a 6.1% pace in the same period a year ago. Even more impressive, in the 13 weeks ending April 23, it's risen at an annualized 11.8% rate, up from a 5.9% pace during the same three months of 2000.
To neomonetarists, that's reason for celebration. Since the mid-1990s, they argue, growth in the money stock has been a reliable indicator of growth in consumer spending — and, therefore, gross domestic product. They point out that a pop in M2 growth (to 7.23%) in late 1998 presaged an economic (and stock market) boom that no one would have thought possible so soon after the Russian debt default and the collapse of Long Term Capital Management. Moreover, the sharp deceleration in M2 growth (to 3.93%) in the second quarter of 2000 came right before GDP (news - web sites) hit the skids late last year.
But critics are quick to point out that money-supply measures have sometimes performed poorly as economic indicators. In the early 1990s, for example, money-supply growth slowed even as consumer spending accelerated and lifted the economy out of recession. It was then that monetary aggregates came to be largely ignored by the Fed and many other economists. (Indeed, Greenspan & Co. recently abandoned their semiannual practice of setting official money-supply targets, though real M2 remains one of the components of the Conference Board (news - web sites)'s Index of Leading Economic Indicators (news - web sites).)
The problem with monetary aggregates, says Lehman Brothers senior economist Ethan Harris, is that financial instruments have become so complex that it's tough to distinguish spending money from saving money. Consider, for example, the money-market mutual fund with checking benefits. Year-to-date, assets in institutional and retail money-market funds have risen at annual rates of 66% and 22%, respectively, according to Miller Tabak chief bond strategist Tony Crescenzi. While that's surely contributed to the surge in the M2 money supply, no one really knows whether investors are simply changing the way they save — in reaction to the bear market in stocks — or preparing to go out and spend more. If people are moving their holdings out of the stock market (where they aren't counted as part of the money supply) and into monetary assets because they're scared, as Harris believes, then M2 growth hardly presages economic and stock-market strength.
Naturally, the neomonetarists see things differently. Although a portion of the money now entering money-market funds is likely to sit there, some of it should be funneled back into the economy and the financial markets as the economic outlook improves, according to this crew. Says Moody's Lonski: ``There will come a point when the private sector has more [cash] than it wants and proceeds to redistribute these assets to stocks, bonds or through spending.'' Mark Zandi, chief economist at West Chester, Pa.-based research firm Economy.com, concurs. ``There's a lot of cash sitting out there,'' he says. ``If attitudes change about the stock market and the economy, that money could be put to work pretty quickly.''
Neomonetarists also point to other gauges of money as evidence that consumers are preparing to spend. Paul Kasriel, vice president and chief U.S.economist at Chicago-based investment firm Northern Trust, notes that M2 minus retail-money funds (funds with assets under $100,000) has risen at a robust 12.9% annualized rate over the past 13 weeks. Moreover, M1 — money used for direct transactions — is up 9% year-to-date, after declining by 3.2% in the first 10 months of last year, according to Crescenzi.
While the moderate neomonetarists think this money-supply growth points to increased spending and a quick economic recovery, hard-core neomonetarists worry that it could prove inflationary. The Shadow Open Market Committee, or SOMC, a group of conservative economists from Wall Street and academia who evaluate Federal Reserve policy, said last Monday that policy makers need to pay ``particular attention'' to monetary aggregates, which contradicts the commonly held view that inflation is dead. ``Since January 2001 the Federal Reserve's aggressive actions to counter decelerating economic growth suggest that it has lost sight of its long-run objective of price stability,'' said the SOMC in a statement. At its current 8% rate, Pierre Ellis, senior economist as New York-based consulting firm Decision Economics, thinks nominal M2 is currently in a ``threatening range.'' Gross domestic product may absorb around 4% of that, but the rest will have to be made up through price increases, he says — meaning inflation is poised for a notable uptick.
Still, most economists think there's little to fear from inflation in the coming months as consumer demand slackens, keeping a lid on economic growth. ``You have to take these [money-supply] numbers with a grain of salt,'' says Zandi. ``They need to be considered along with other economic indicators.'' And the vast majority of data suggests that the economy remains quite sluggish.
But if the money supply may not be the best economic indicator out there, it's still worth watching for hints of an imminent economic recovery. ``By no means does it ensure a revival of economic activity by the end of this year, but it very well suggests that cash balances may be building up to finance much faster business activity six to 12 months hence,'' says Lonski. ``Besides, I'd rather be in an economic slump where money supply is growing than in an economic slump where it's not.'' Anybody who's been around long enough to have boogied to Donna Summer or sat through a first run of ``Urban Cowboy'' should remember what that feels like.>> |
