Why is M2 above its 1998 range, and what does it mean for monetary policy?
M2 expanded at a fairly rapid rate of 5-1/2 percent in 1997, and so far this year has accelerated to nearly an 8 percent rate.* Both of these growth rates are above the range set by the Fed for M2 of 1 to 5 percent in both 1997 and 1998.
There are a number of reasons for recent rapid growth in M2. First, overall economic activity has been robust and this tends to raise people's demand for M2. Second, the volume of mortgage refinancings has surged as mortgage interest rates have fallen. This has led to increased holdings of liquid balances while these transactions are being settled. Finally, long-term interest rates have fallen relative to short-term interest rates, including those paid on M2 balances, making the latter instruments more attractive places to hold savings.
What does this mean for monetary policy? Under current operations, the Fed does not emphasize the aggregates in formulating monetary policy, but simply includes them among a long list of indicators it watches. The reason is that M2 is not considered to be a very reliable indicator of spending in the economy. Deregulation has allowed banks to pay market interest rates on the deposits in M2, making them closer substitutes for other financial assets available in the market. At the same time, innovation has created market substitutes for the deposits in M2. A good illustration of the unreliability of M2 as an indicator of spending comes from the early years of the current expansion: the growth rate of M2 was rather weak in large part because people were putting more of their funds into stock and bond mutual funds, but slow growth in M2 was not associated with a weak economy.
*M2 includes currency, checkable deposits, liquid savings instruments, and small time deposits at commercial banks and savings and loans.
For Further Reading
Judd, John P., and Bharat Trehan. 1992. "Money Credit, and M2." FRBSF Weekly Letter 92-30 (September 4).