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The Fed Isn't Fiddling With Money Supply
By Aaron L. Task
Senior Writer
10/30/2003 09:16 AM EST
Updated from 7:11 a.m. EDT
Money supply growth has slowed noticeably of late, prompting speculation that the Federal Reserve is attempting covertly to curtail economic growth, even as it remains reluctant to actually tighten.
But you probably shouldn't worry about the recent contraction in money supply aggregates, assuming it remains a short-term phenomenon. (Certainly money supply proved no restraint in the third-quarter; the advance GDP report showed growth of 7.2%, well in excess of the 6% forecast by economists.)
Why? A host of observers say the concern is unwarranted and misguided for the following reasons: A contracting money supply is mainly a function of investors pulling money out of money market funds, ostensibly a positive development.
Furthermore, they dispute arguments the Fed is restricting money supply, measures of which may no longer accurately reflect the modern economy. And the traditional measures of money supply have recently proved to be faulty prognosticators.
For the week ended Oct. 6, M3, a large measure of money supply, was $8.88 trillion, down from its peak of $8.988 trillion the week of Aug. 11; that's the first decline in a three-month period since August 1993. In the last two months, M2 and M3 have fallen at annual rates of 4.7% and 5.3%, respectively, the biggest declines since the data were first compiled in 1960, according to Ed McKelvey, senior economist at Goldman Sachs. (The next weekly data will be reported by the Fed later Thursday.)
Simultaneously, the growth rate of MZM, the broadest measure of money in circulation, has slowed considerably as well. (A definition of the various monetary aggregates can be found here.)
While the recent dramatic short-term movements are disconcerting, many Fed watchers say the worry is misguided. Notably, M1, M2 and M3 were growing at seasonally adjusted annual rates of between 6.8% and 8.1% for the 12 months ended Sept. 30. For the 13 weeks ending Oct. 14, their growth rates all exceed 7%.
Don Hays, president of Hays Advisory Group, said the recent decline is particularly startling because investors have become accustomed to unusually high money-supply growth. Annualized money-supply growth above 10% is historically unusual, he observed, and only became commonplace recently as the Fed responded to crises such as the collapse of Asian currencies in 1996-97, Russia's default and the implosion of Long Term Capital Management in 1998, the prelude to Y2K in 1999, and the Sept. 11, 2001, terrorist attacks.
The recent drop in MZM's growth rate is a "test ... to see how the stock markets, but especially the currency and bond markets, react," Hays suggested. "I would suspect that [Fed chairman Alan] Greenspan would love to see money supply neutralize in that 'optimal' 5.5% to 7% range, as long as no new currency disaster came along."
The Message of the 'M's'
Goldman's McKelvey argued the short-term slowdown is largely a result of investors taking money out of money market funds and putting it in riskier assets, notably equities. In September, equity mutual funds enjoyed inflows of $17.1 billion while tax-free money market funds sustained record outflows of $72.7 billion, according to AMG Data. Taxable bond funds had inflows of $1.1 billion last month, although government bond funds suffered outflows.
M2, M3 and MZM all include money market mutual funds; thus, such a dramatic reduction in those accounts would weigh on the monetary aggregates. (One can argue the merits, but economists generally believe investors seeking more risk is positive, and natural, at the onset of a recovery.)
Outflows from money market funds have "depressed the broader measures M2 and M3 [but] these outflows have been accompanied by strong inflows into bond and equity mutual funds," McKelvey commented in a recent report. "This is not a reason to become more pessimistic."
Nevertheless, some observers have become quite pessimistic about the recent decline in money supply.
"The Federal Reserve, the controller of monetary growth, has slammed on the brakes as evidenced by the lack of growth in monetary aggregates," Paul Nolte, director of investments at Hinsdale Associates recently declared, as noted here. Declining money supply "may be foreshadowing a tighter monetary policy sooner rather than later."
Other pundits have used the term "stealth tightening" to describe the Fed's presumptive efforts. (The inverse arguably occurred in late 1999, when money supply increased dramatically in advance of Y2K, even as the Fed was actually tightening.)
But "the Fed does not control the money supply," countered RealMoney.com contributor Howard Simons. "It adds or subtracts free reserves in the banking system by buying or selling Treasury securities for its own account. Actual money supply is then set as a function of bank lending activity."
The Fed can influence money supply by raising or lowering requirements on bank reserves, adjusting the discount rate at which banks can borrow from the Fed and via open market operations, namely the trading of government securities.
Peter Kretzmer, senior economist at Bank of America, further observed Fed open market operations are "done to target the funds rate," noting there's been no evidence of Fed action inconsistent with a 2% discount rate or 1% fed funds rate. (Fed funds is the rate at which banks with excess reserves at Federal Reserve District banks lend to other financial institutions.)
"I don't think there's any explicit Fed attempt to do anything," Kretzmer said.
Why commercial and industrial lending and monetary velocity remain low in the face of a 1% funds rate is a more compelling question than the absolute developments in money-supply measurements, Simons recently observed. It would seem the Fed is providing ample supply of liquidity, but perhaps there isn't enough demand for it.
Still, C&I loans generally lag in an economic recovery and "I expect in the fourth quarter we're going to see businesses step up borrowing to finance inventories," said Paul Kasriel, chief U.S. economist at Northern Trust Co. in Chicago. If they don't, "all bets are off" in terms of the sustainability of the recovery.
Somewhat lost in the money supply shuffle is the fact that monetary aggregates have demonstrated poor prognosticating abilities in recent years. As the chart above demonstrates, money-supply growth was well above 10% for most of 2001 and 2002; yet, the economy and stocks struggled.
The negative wealth effect of the bear market and its impact on behavior overwhelmed whatever benefits the economy may have gotten from the money supply surge, Kretzmer suggested. "It hasn't been a great decade so far for short-run forecasting using money aggregates."
On a related note, many changes in how the economy operates often aren't captured in commonly cited money supply gauges. "Back in the old days ... banks lent, the lent funds were deposited at other banks and they re-lent with the reserve requirement haircut," recalled Simons. "We didn't have GE Capital, GM Acceptance, Ford Motor Credit or mortgage intermediaries," whose oft-massive financing activities may not be reflected in the M's.
But a spotty track record and questions about their composition hasn't stopped some participants from worrying about the recent decline in money supply. Whether it leads to a similar decline in economic activity remains highly debatable.
Aaron L. Task writes daily for TheStreet.com. In keeping with TSC's editorial policy, he doesn't own or short individual stocks, although he owns stock in TheStreet.com. He also doesn't invest in hedge funds or other private investment partnerships. He invites you to send your feedback to Aaron L. Task.
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