FRBSF Economic Letter
98-07; March 6, 1998
Is It Time to Look at M2 Again?
In July 1993, Chairman Greenspan informed Congress that the monetary
aggregate, M2, had been "downgraded as a reliable indicator of financial
conditions in the economy, " reflecting the fact that "the historical
relationships between money and income and between money and the price
level [had] largely broken down." More recently, however, there have
been signs that M2 has resumed a more "normal" relationship
with key macroeconomic variables. If true, such a development would be
especially important now in light of recent robust M2 growth and would
suggest the economy will continue to grow at robust rates in the near
future. In this Letter we review the evidence on the stability
of the traditional relationships between M2 and key macroeconomic variables
and try to determine whether M2 will provide useful information about
the future course of the economy.
The role of monetary aggregates
in the conduct of monetary policy
It is easiest to understand the role of monetary aggregates in the conduct
of monetary policy by looking at the Fed's experience with monetary targets.
The Fed began to pay more attention to monetary aggregates in the 1970s,
especially M1. M1 is a "narrow" monetary aggregate, consisting
of money balances held as currency and checking accounts. M1 had two characteristics
required of a desirable target variable: it had a reasonably close relationship
to economy-wide spending, and it was relatively easy to control through
Fed policy. Both properties were the result of legal restrictions on checkable
accounts. Checking accounts in M1 paid no interest; at the same time,
it was not possible to write checks on other types of accounts. The restriction
on interest payments meant consumers were unlikely to put savings balances
in M1. The two restrictions together meant there was a reasonably close
correspondence between M1 and transaction balances in the economy. The
restriction on deposit rates also meant that banks could not offset interest
rate changes made by the Fed, so a change in market interest rates had
a direct impact on the cost of holding money. In this environment, the
ultimate effect of a policy action on policy goals such as output growth
or inflation -- which are not directly controllable by the Fed -- could
be gauged by looking at the short-term response of M1 to such a move.
Changes on the demand side
The unique position of M1 eroded over time as a result of both deregulation
and financial innovation. Checking accounts began to pay explicit interest,
and it became easy to write checks on accounts outside of M1. As a consequence,
firms and households had little reason to distinguish between cash balances
held inside and outside of M1. This caused the stable relationship between
M1 and economy-wide spending to disappear. To take one example, small
changes in interest rates caused individuals to move in or out of M1,
which in turn led to substantial swings in the aggregate's growth rate
that had little to do with individuals' spending plans.
In response, the Fed downgraded M1 in 1987 and turned its attention
toward the broader monetary aggregates, especially M2. M2 includes M1
plus small time deposits and other instruments such as noninstitutional
money market mutual funds. In view of all the changes in the financial
environment that had taken place, M2 was unlikely to be as useful for
policy as M1 had once been. Nevertheless, since it contained most of the
close substitutes to M1, it was expected to internalize many of the portfolio
shifts that had plagued M1.
M2 did not last long as a target variable. In the early 1990s, the relationship
between M2 and economy-wide spending changed noticeably. To provide some
perspective on the magnitude of the change, Figure 1 shows
the velocity of M2 since the 1960s. (The velocity of M2 is defined as
the ratio of nominal GDP to the quantity of M2, and can be thought of
as a measure of turnover.) Slow growth of M2 deposits in the 1990s caused
velocity to rise well above the maximum levels seen prior to this decade.
What can explain this sharp rise in velocity? Continuing financial innovation
played a big role, especially innovation in the area of bond and stock
mutual funds: the cost of acquiring them fell markedly, and they grew
explosively, both in number and variety. For households and firms, these
changes meant a gradual increase in the availability of close substitutes
for M2.
The Fed's Survey of Consumer Finances provides one measure of the shift
out of M2 and into mutual funds over this period. In 1989, M2 (less currency)
accounted for almost 27% of consumers' financial assets, yet by 1995 the
share of M2 had declined by more than one-third to account for only 17%
of consumers' financial assets. During the same period, the share of mutual
fund holdings grew about 2.5 times to represent 13.2% of financial assets
in 1995.
Was this shift a one-time event? More generally, is recent financial
innovation unusual and unlikely to continue? Our opinions on this issue
are basically the same as those of Woodford (1997), who states that "...there
is every reason to expect further innovations, due to improvements in
information processing and to increased creativity in the evasion of the
remaining regulatory constraints...." And, " ... from the standpoint
of economic theory, there is no reason to believe that there is any uniquely
rational or efficient set of arrangements that result in any stable demand
for money at all" (p. 1).
The role of the supply side
While increased substitution on the demand side is a big part of the
story, it does not completely explain the shift in M2 velocity during
the 1990s. Financial innovation had been a factor before this dramatic
shift, so why did individuals suddenly decide to move out of M2? Some
recent research suggests the answer to this question lies in the banking
sector. To understand this explanation, recall that most of the balances
in M2 represent the liabilities of banks and thrifts, and any change in
these liabilities must be linked to changes elsewhere in banks' portfolios.
For instance, if the unusually slow growth in M2 reflected a decision
by households to hold less of the aggregate, banks could respond either
by cutting back on assets (such as loans to firms or households) or by
increasing other kinds of liabilities (which would be likely to show up
in increased M3, an even broader aggregate).
The other possibility is that the slowdown in M2 reflected developments
originating from the supply side. The early 1990s were a time of considerable
strain in the banking and thrift industries, when an unusually large number
of thrifts were "resolved" (either shut down or merged with
healthy institutions) by the Resolution Trust Corporation. Some banks
also were constrained from lending, since the amount of capital they were
legally required to hold against various assets had gone up. Lown, Peristiani,
and Robinson (1997) show that the anomalous behavior of M2 was localized
in deposits held at troubled thrifts and capital-constrained banks. Specifically,
they show that there was little change in the relationship between M2
deposits at unconstrained banks and the traditional determinants of these
deposits, such as income and the opportunity cost of holding money. By
contrast, in the case of resolved thrifts and capital-constrained banks
this relationship fell apart.
If this evidence stands up to further scrutiny, it has important implications
for understanding the usefulness of M2 as an indicator. To see why, consider
what would "normally" happen as the banking sector (or thrifts)
undertook a reduction in loan portfolios. To shrink liabilities, banks
would reduce the rates they offered on deposit accounts; consumers would
find it more attractive to hold other kinds of assets, and so would shift
assets out of M2. This would shrink the quantity of M2 but would not cause
the relationship between M2 and its traditional determinants to shift.
The research by Lown, et al., suggests that the slow M2 growth during
the early 1990s reflected something more than the simple adjustment process
just described. Households appear to have reacted to the supply side disturbance
by taking money balances out of M2, even though they could have placed
these balances at other healthy banks or thrifts and earned comparable
rates of return. In fact, this is what they should have done if they were
concerned about the quantity of their M2 holdings, that is, if the demand
for M2 were well-defined. In other words, this evidence suggests that
there is no longer a well-defined demand for the aggregate: households
and firms see little difference between accounts in M2 and those outside,
so disturbances on the supply side can cause them to move outside M2 and
make it appear that the demand for the aggregate has shifted. This apparent
shift (away from the previous trend) can be seen in Figure 2, which
shows that M2 velocity increased steadily over the early 1990s, while
the opportunity cost of holding M2 first fell and then rose. (The opportunity
cost of M2 is the interest income that an individual gives up by not holding
higher yielding assets instead of M2.)
Implications and conclusions
To summarize, we have argued that ongoing financial innovation has spurred
the creation of financial assets outside M2 which are very good substitutes
for those available inside M2. As a result, the demand for M2 is no longer
well-defined. Just how much has changed became evident in the early 1990s,
when a large shock to the supply side led to a big "shift" in
the demand for M2.
It is possible to argue that the early 1990s were a transitory period
of institutional turbulence and, further, that any resulting portfolio
shifts have been completed since then. Indeed, recent data in Figure 2 appear
consistent with this argument, since the relationship between M2 velocity
and its opportunity cost looks like it might be stabilizing at a new,
higher level. However, our interpretation of developments in the early
1990s suggests this argument is incorrect, since the observed instability
was a result of fundamental changes in the financial system -- such as
the innovations associated with mutual funds -- that are unlikely to be
reversed. In particular, the existence of close substitutes for M2 means
that the aggregate is likely to remain susceptible to many developments
unrelated to the near-term spending plans of households and firms.
As a consequence, it will remain difficult to tell what a change in
M2 means for the near-term performance of the economy. To take a recent
example, some observers have suggested that the rapid M2 growth during
the last few months reflects uncertainty about financial market developments,
as investors have turned to M2 as a safe haven from stock market selloffs.
To the extent that stock market volatility reflects concerns about the
health of the economy, the recent acceleration in M2 may be signaling
slower growth instead of an increase in growth, as traditional theory
suggests. We can imagine other similar disturbances that could once again
"shift" the relationship between M2 and its traditional determinants.
Because of these considerations, we think it would be unwise to place
too much reliance on M2 in the formulation of monetary policy.
Kelly Ragan
Research Associate
Bharat Trehan
Research Officer
References
Greenspan, Alan. 1993. Statement to Congress. Federal Reserve Bulletin
79 (September) pp. 849-855.
Lown, Cara S., Stavros Peristiani, and Kenneth J. Robinson. 1997. "What
Was behind the M2 Breakdown?" Mimeo. Federal Reserve Bank of New
York (August).
Woodford, Michael. 1997. "Doing without Money: Controlling Inflation
in a Post-Monetary World." NBER Working Paper 6188 (September).
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 or to the author. Mail comments
to:
Research Department
Federal Reserve Bank of San Francisco
P.O. Box 7702
San Francisco, CA 94120
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