M2
In Brief
Money supply figures, and M1 specifically, once were the most important
release to watch in the Treasury market, as the Fed directly targetted M1
growth in the early 1980s. The focus on money supply has long since been
abandoned, however. To the extent that money supply is still monitored by the
market, M2 is the favored monetary aggregate. The Fed still targets both M2 and
M3 in a rhetorical sense, but these targets mean little when it comes to policy
decisions. If the Fed misses its target, it is more likely to change the target
than it is to change policy. In 2000, the Fed finally abandoned the targets
altogether, thereby removing any remaining emphasis on this one-time star
release.
In Depth
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. This article offers 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.
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
M2 is 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, and later
setting target ranges for M2 and M3. Finally, in 2000, the Fed abandoned these
money targetting altogether.
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.
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. |
