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FRBSF

WEEKLY LETTER

September 28, 1990

Interpreting Recent Money Growth
From March to July of this year, the nation's stock
of money grew extremely slowly. The Federal Reserve's M2 monetary aggregate expanded at a
mere one percent annual rate over this period,
and the broader money measure, M3, contracted
over this period.
Slow growth in the money stock can be troubling, since in the past, such slowdowns sometimes have preceded slowdowns in the pace of
economic activity. Whether the sluggish growth
of M2 portends weaker economic activity, however, depends on what caused it. This Letter
looks at what lies behind the weak money numbers, and draws implications for the reliability
of M2 as a guide to monetary policy.

Growth ranges
The Federal Reserve sets annual ranges for
growth in its M2 and M3 aggregates. M2
comprises currency, transactions deposits,
small time and savings deposits, general
purpose/broker-dealer money market mutual
fund shares (MMMFs), overnight repurchase
agreements, and Eurodollar deposits. The
broader aggregate, M3, adds large certificates
of deposit, institution-only MMMF shares, term
repurchase agreements, and term Eurodollar
deposits.
The growth ranges adopted for M2 and M3 are
intended to provide for monetary growth that is
consistent with achieving the Federal Reserve's
long-run policy goals of price stability and sustained growth in output. This year, the Federal
Reserve establ ished a three-to-seven percent
growth range for M2 and a one-to-five percent
range for M3.
The Federal Reserve also publishes data on a
narrower monetary aggregate, M1, which comprises currency and checkable deposits. But the
Fed has not established a range for this aggregate
since 1985 largely because movements in this
aggregate no longer track movements in income
and prices very we! I.

Since the range for M1 was dropped, moreover,
the monetary aggregates as a group have been
de-emphasized in the conduct of monetary policy. Although movements in M2 (and possibly
M3) continue to be associated with long-run
trends in the price level, short-run movements
in these aggregates often are unrelated to trends
in income and prices. Last year, for instance, M2
growth decelerated sharply in April, and actually
contracted in May, leaving the aggregate well
below its range (see Chart 1). This weakness was
not the result of a slowing economy, nor a tightening in monetary policy, but instead, appears
to have been related to higher-than-expected
income tax payments.

Chart 1
M2 with Growth Rate Ranges

Billions
of Dollars

3,500
3,400
3,300
Growth Range
(established
February 1990)
r-o-.-r....-T""-'r-T"".-r....-T...,-,--.-.-r-,-,-...,...,--.-r-r-,..,-j

b

1988

~

_

~

b

~

_

1989

~

b

3,200
3,100
3,000

1990

Is the recent weakness unusual?
Given that the monetary aggregates increasingly have been buffeted by developments that are unrelated to movements in
economic activity, it is important to examine
the causes of this slowdown to determine the
appropriate policy response. The first step
is to examine the recent weakness in M2 in
light of its historical behavior to see whether this
weakness is "unusual:' To do so, we estimated
an equation that imposes a long-run relationship
between the levels of M2 and interest rates,
income, and prices, but allows M2 to deviate
from this relationship in the short run. Given
this estimated relationship, we used the actual

FRBSF
values of interest rates, personal income, and
prices to predict the levels of M2 that would
have prevailed if no other factors had been
at work.
Chart 2 depicts these forecasts, which are
centered within an "error band" that allows
for "normal" deviations of M2 from its long-run
level. Values outside this band would be unlikely
given the historical range of disturbances to M2,
and thus suggest that factors other than the levels
of interest rates, inflation, and income have been
exerting an unusually strong influence on the
behavior of M2.

Chart 2
Actual and Predicted M2
(Based on monthly estimation from Jan. 1978 to June 1989)

Billions
of Dollars

What is more notable is that growth in the nontransactions component of M2 also decelerated
sharply. A major contributor to this deceleration
was a decline in MMMF shares. MMMF shares
grew quite rapidly in 1989 and into the first quarter of this year, but were flat in April and contracted at a 20 percent annual rate in May.
Growth resumed in June and July, but at a
modest pace.
The deceleration in the growth of money
fund shares may have been due to portfolio
adjustments associated with a rise this year in
longer-term yields. Specifically, investors may
have shifted funds from short-term investments
like MMMF shares that are included in M2 to
higher-yielding, longer-term, fixed-income and
equity instruments not included in M2 or M3.

3,400

3,300

3,200

.--,---,--,-,--.--,..----,--,-,----.,-,..---,------i 3,100
Jul
Jul
Sep
1989
Dashed lines define an 'error band' that is plus/minus two standard errors from the predicted values.

As the chart shows, from mid-1989 to March
1990, M2 was growing at about the pace one
would predict, given the levels of interest rates,
inflation, and economic growth that prevailed
at the time. In the first quarter of 1990 actual
M2 was lower than predicted M2, but still well
within the error band. After March, however, M2
growth slowed considerably. On account of this
slowdown, the level of M2 was outside the error
band from May to July, indicating that growth
over the March-July period had been unusually slow.

What accounts for slow growth?
A number of factors help to account for this
behavior. Some of the weakness in M2 can be
traced to sluggish growth in its key M1 transactions account components: demand deposits and
NOW accounts. However, since M1 has not been
very reliable over much of the "post-deregulation" era, weakness in that portion of M2 by
itself is not very revealing.

To the extent that these types of portfolio
adjustments lie behind the decline in money
fund shares and, thus, the sluggish growth in
M2, the recent unusual behavior of M2 is unlikely to be indicative of tight monetary policy.
Nor do these portfolio shifts provide clues regarding the future course of the economy.

Thrift restructuring
Another factor that contributed to the slow
growth in M2 was sluggish growth in smalldenomination time and savings deposits. These
deposits rose at only about a 1V2 percent rate
from March to July, down from about a four percent rate in the first quarter. Thrift institutions'
deposits have contracted significantly. And although commercial banks have captured some
of these deposits (some directly through acquisitions of thrifts), the rise in bank deposits has
only partially offset the contraction at thrifts.
To a large extent, these developments are the
result of a change in banks' and thrift institutions' deposit pricing strategies associated with
the ongoing restructuring in the thrift industry.
Specifically, the closure of insolvent thrifts that
were paying premium rates to attract deposits
has enabled competing institutions to lower
their deposit rates. Indeed, data on interest rates
on money market deposit accounts and smalldenomination time accounts show that rates on
commercial bank deposits recently have been
lower than normally would be expected given
prevailing levels of other market rates. For many

investors, this change in pricing has made deposits less attractive than other financial instruments, such as Treasury bills, that are not
included in M2.

aggregate have been a good measure of the potential impact of a credit crunch. Data on credit
extended by banks and other sources should
prove better guides than M2 in this case.

Credit crunch?

In any event, data through late August suggest
that M2 growth has picked up, with the Ml and
MMMF components providing much of the
boost. This further complicates the interpretation
of the recent behavior of M2. Historically, such
a pickup in growth would have been seen as a
positive development for economic activity. In
today's environment, however, renewed growth
in transactions deposits and MMMF shares could
reflect an increased demand for liquidity in
response to concerns about developments in
the Middle East, the rise in oil prices, and the
direction of the economy.

In addition to the elimination of high-flying
thrifts, slower growth in lending by commercial
banks also may be partly responsible for the less
aggressive pricing of deposits and the resulting
slow growth in M2. It has been argued that one
factor contributing to this slow loan growth is the
so-called "credit crunch;' which, many argue, is
due to a decline in the quality of loan portfolios
at some banks and a perception that regulatory
standards have become more stringent.
To the extent the sluggish growth in M2 is the
result of such a credit crunch, it could be signalling an impending slowdown in economic
activity. However, the severity of the credit
crunch and, therefore, its impact on the economy
are the subject of considerable debate. For example, slow loan growth simply may result from the
slowdown in economic activity in recent months.
In addition, slower bank loan growth could be
offset to some degree by an expansion in credit
from other sources. Nevertheless, to counter
concerns that a credit crunch might slow the
economy, the Federal Reserve eased monetary
policy modestly in July.

Implications for M2's future role
Our analysis of the recent behavior of M2 is
not very comforting as far as the future role of
the aggregate is concerned. Experience over the
last few years suggests that M2 is susceptible to
many different kinds of disturbances that are
unrelated to key macroeconomic variables. It
appears that many investors do not perceive
much difference between nontransactions accounts within M2 and those outside M2. Consequently, M2 growth can change because of
portfolio reallocation decisions, without there
being substantial implications for the economy.

Is M2 a useful guide?
Unusual movements in M2 warrant investigation, both because the aggregate appears to have
a stable long-run relationship with interest rates,
income, and prices, and because the Federal
Reserve still sets ranges for the aggregate. It
appears that from March to July of this year,
M2 was distorted in part by portfolio shifts from
money market mutual funds and the resolution
of insolvent thrift institutions. Neither of these
developments would suggest that recent M2
growth provides any information about the
future course of the economy.
At the same time, it is possible that M2
reflected some slowing in credit extensions
at banks, which could have had an effect on
economic activity. Nonetheless, given the other
influences on the behavior of M2 in recent
months, it is not clear whether changes in this

The deregulation of financial institutions over
the last decade has exacerbated this problem
because banks and thrifts are now free to vary
the rates they offer on various deposits. Consequently, changes in the degree of substitutability
between various kinds of accounts make M2
more susceptible to disturbances, and changes
in the way in which banks and thrifts price these
accounts make such disturbances more likely.
The extent to which these developments will
affect the long-run relationship between M2
and key macroeconomic variables remains to be
seen. However, these developments do suggest
that M2 is unlikely to provide reliable signals
about cyclical movements in the economy.

Fred Furlong
Research Officer

Bharat Trehan
Senior Economist

Opinions expressed in this newsletter do not necessarily reflect the views of the management of the Federal Reserve Bank of
San Francisco, or of the Board of Governors of the Federal Reserve System.
Editorial comments may be addressed to the editor (Barbara Bennett) or to the author.... Free copies of Federal Reserve
publications can be obtained from the Public Information Department, Federal Reserve Bank of San Francisco, P.O. Box 7702,
San Francisco 94120. Phone (415) 974-2246.

Research Deportment

Federal Reserve
Bank of
San Francisco
P.O. Box 7702
San Francisco, CA 94120