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April 20, 1979 Wh y Redefinethe M's? Everyone is becoming more sophisticated about money and finding new ways to economize on checkingaccount balances. Many of the recent regulatory changes and financial innovations permit individuals, as well as businesses and governmental units, to improve cash-management practices. Butthe very effectiveness of these innovations is causing problems for the Federal Reserve, as it attempts to use money-supply measures in achieving its monetary-policy goals. Deposit shifts are occurring among the demand, savings and time components that make up the monetary aggregates (M 1, M 2, M 3, et al.), and shifts are also occurring among depository institutions, and between deposits and nondeposit substitutes. These alter the previously observed relationships of the money aggregates with GNP, income, and interest rates, and thus make aggregate behavior difficult to interpret. To reflectthe impact of recent financial innovations, the Federal Reserve Board of Governors presented a proposal in the January Federal Reserve Bulletinfor redefining the "M's" by "grouping together similar kinds of deposits at all depository institutions." Changesin demandbalances Many of the recent innovations and regulatory changes have limited the growth of demand deposits at commercial banks. At the same time, they have caused shifts to new-type transaction balances tied to interestbearing accounts - such as negotiable orders of withdrawal, automatic transfers from savings, and credit union share drafts - at all types of depository institutions. The impact of these innovations has varied widely among the major sectoral holders of demand balances, causing significant changes in the composition of demand deposits, the major component of M1. For some sectors, substantial economies in demand balances have already taken place; for others, the process is far from complete or just getting underway, and these shifts will further alter the behavior of M 1. The nonfinancial business sector, which accounts for about 40 percent of total demand deposits, for years has economized considerably on its demand-balance holdings. By utilizing a wide-range of short-term options for investment of balances in excess of immediate needs, large corporations are approaching the potential minimum in their holdings of transaction balances. In addition, their "required" demand balances are declining as banks, in response to competitive pressures for corporate loans, substitute fees in lieu of requiring "compensating" demand balances on loan extensions. Medium- and small-sized business firms have not matched, in relative terms, the demand-depositeconomies achieved by large corporations, mainly because size constraints limit their access to the wide range of shortterm investment options available to larger firms. However, they have been able to improve their cashmanagement practices by shifting funds from demand balances to savings accounts, as a result of a November 1975 regulatory change that permits businesses to hold up to $150,000 in savings deposits. (continued on page 2) A similar cash-management tool became available to local governmental units in November 1974 through a regulatory change that permits domestic governmental units to hold savi ngs deposits. At the state level, the spread of sophisticated cashmanagement techniques, utilizing pooled-investment accounts, has significantly constrained the growth of public demand deposits. For both state and local governments, further declines in demand-deposit use can be expected because of legislative and regulatory trends liberalizing investment alternatives for governmental units, and because of the spread of the pooled-investment concept to local units as well as to more and more states. Shift in consumerdeposits Recent regulatory changes have had their most dramatic impact on the consumer sector, which accounts for about one-fourth of total demand deposits. In its money-supply redefinition proposal, the Federal Reserve listed a number of changes that have enhanced the ability of individuals to economize on demand balances either directly through issuance of negotiable instruments drawn on interest-bearing accounts or indirectly by automatic withdrawals from savings to checking accounts, or by preauthorized telephone and point-ofsale transfers from savings accounts. The greatest impact came last fall from the authorization of automatic transfers from bank savings accounts and the extension of N OW authority to depository institutions in New York 2 State. Mutual money-market funds, which provide limited withdrawal privileges in negotiable form, also have been attracting significant amounts of consumer funds. The extent to which consumers use the new transaction-type accounts N OW's, CU share drafts, and ATS accounts - depends on their effective cost compared with the cost of regular checking accounts. When minimumbalance requirements are met, most such accounts impose no transaction or fee charges on withdrawals. Consumers using these new interestbearing transaction accounts can effectively reduce their demanddeposit holdings to a "zero" amount. This projected economizing of consumer demand deposits will significantly affect the elasticity of current M,'s response to income growth. Savingsand time shifts Financial innovations have also affected the savings and time-deposit components of currenfM 2 and M 3 , the broadly defined money measures. The new transaction accounts (ATS, N OW's and CU's) are drawing funds from regular savings accounts at both banks and thrifts, as well as from demand deposits. Households also have shifted massive amounts of funds from savings into the more attractively priced "money-market certificates" (M MC's) which have been available since mid-1 978 at banks and savings and loan associations. (These f1oatingrate 6-month time certificates, in minimum denominations of $10,000, are tied to the 26-week bill auction rate). Since thrift institutions could offer M M C's at a favorable rate differential prior to last month, substantial amounts of funds also shifted from banks to thrifts. If the concept of applyi ng money-market rates spreads to smaller-denomination time certificates, the shift out of the savings component into time deposits will accelerate further. The heavy issuance of M M C's is further altering the liquidity of the time-deposit component of the money supply by concentrating funds in 6-month maturities. This component had become significantly less liquid as a resuIt of the lengthen i ng of matu rities at both banks and thrifts following the 1973 and 1 974 increases in regulatory rate ceil ings on longer-term certificates. But market-rate certificates affect the broadly defined monetary aggregates most significantly in another way, by making consumer time deposits less subject to disintermediation when interest rates rise. ProposedM's The new Ml aggregate, as proposed by the Board, would include the current components - currency and demand deposits - plus all other transactiontype accounts at banks and thrift institutions (less deposits of foreign commercial banks and official institutions). Inclusion of all these accounts would eliminate the effects of the shifts from consumer demand deposits to the new interest-bearing transaction accounts. But since these accounts consist of savings-type funds as well as those needed for transaction purposes, the proposed Ml would be greater than the current M 1. If the proportion of these highly interest-sensitive savings balances becomes significant, the demand elasticities of the proposed Ml with respect to interest rates will tend to differ from those of the current Ml measures. The proposed M2 aggregate wou Id include the components of the new Ml aggregate plusregu lar savings deposits 3 (i.e., savings deposits as currently defined less transaction-type accounts) at both banks and thrift institutions. The addition of "regular" savings deposits would "wash out" the effects of shifts from regu Iar savings accou nts to transaction-type balance accounts. It would also cancel out the effect of fund transfers between banks and thrift institutions for all the deposit components included in M 2. The proposed M3 would add to the new M2 aggregate the time deposits of all maturities and denominations at both banks' and thrift institutions. It would include large-denomination' ($1 00 ,000 and over) negotiable CO's, which currently areexcluded from both M2 and M 3 . Since this broader proposed aggregate would include all types of accounts - demand, transaction-type, savings and time - at all depository institutions, its movements would not be affected by the shifts occurring among deposit categories or among institutions. ' The public's monetary-asset holdings are becoming increasingly fluid, atleast partly because of the continued rapid pace of regulatory and financial innovations. No one aggregateor group of aggregateswill be optimal for all purposes. In recognition of this fact, the Board proposes to publish separately the "building block" components of the aggregates,so thatfinancial analysts will be able to monitor the impact of financial changes in more detail. RuthWilson UOl8U!4SEM.4Eln• uo8aJO• EpEi\aN• o4EPI !!EMEH • E!UJOJ!!t?::::> • EUOZPV • E>fsEIV 'JUt'::> 'o:)sput'J:Iut'S C:SL'ON OIYd :l9\' lS Od 'S'(1 11\,"" SSV1::> lSHI:I JJ. BANKINGDATA-TWELFTHFEDERAL RESERVE DISTRICT (Dollar amounts in millions) Selected AssetsandLiabilities large CommercialBanks Amount Outstanding 4/4/79 Change from 3/28/79 Loans(gross,adjusted)and investments* Loans(gross,adjusted)- total# Commercial and industrial Realestate Loansto individuals Securitiesloans U.S. Treasurysecurities* Other securities* Demand deposits - total# Demand deposits - adjusted Savingsdeposits - total Time deposits - total# Individuals, part. & corp. (LargenegotiableCD's) 123,612 101,211 29,689 35,855 20,797 1,869 7,855 14,546 43,499 30,961 30,219 49,891 40,588 17,664 'v\eek ended 4/4/79 1,312 1,236 275 59 80 308 81 5 4,392 2,061 319 352 153 217 W!ekIyAverages of Daily Figures MemberBankReserve Position ExcessReserves(+ )/Deficiency (-) - - Changefrom yearago@ Dollar Percent + 17,258 + 16,781 + 3,898 + 7,670 16.22 19.87 15.11 NA NA 31 446 2,451 1,373 569 8,473 7,981 2,620 NA NA 0.40 3.16 5.97 4.64 1.84 20.45 24.47 17.42 + + + + - + + + 'v\eekended 3/28/79 - Comparable year-agoperiod 52 65 13 28 19 9 94 15 79 + 1,506 + 866 + 332 + + 481 + 467 Borrowings Net free reserves(+ )/Net borrowed(- ) FederalFunds- SevenLargeBanks Net interbank transactions [Purchases(+ )/Sales(-)] Net, U.s. Securitiesdealer transactions [Loans(+ )/Borrowings (- )] 222 * Excludestradingaccountsecurities. # Includesitemsnot shownseparately. @ Historicaldataarenot strictlycomparable dueto changesin the reportingpanel;however,adjustments havebeenappliedto 1978datato removeasmuchaspossiblethe effectsof the changes in coverage. In addition,for someitems,historicaldataarenotavailabledueto definitionalchanges. Editorialcommentsmaybe addressed to the editor(WilliamBurke)or to theauthor..•. Freecopiesof this andother FederalReserve publicationscanbeobtainedbycallingor writing the Public InfonnationSection,FederalReserve Bankof SanFrancisco,P.O.Box7702,SanFrancisco 94120.Phone (415)544-2184.
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