Positive Economic Commentary
What’s Up - Or Down, As The Case Is - With Money?
November 14, 2003
What’s been the behavior of the M2 money supply in recent months?
As shown in Chart 1, its growth has slowed sharply. In the two months ended October, M2 contracted at an annualized rate of 4.93%. In sharp contrast, in the two months ended June, M2 grew at an annualized rate of 14.81%. In the history of M2 data, which goes back to 1959, there has never been a two-month contraction in this monetary aggregate of the magnitude that has just occurred.
Why should we care about the behavior of M2?
Because the behavior of M2, adjusted for prices, has been a good, albeit not perfect, leading indicator of price-adjusted, or real, consumer demand for goods and services. This is illustrated in Chart 2. Looking at year-over-year percent changes, the highest correlation, 0.70, between the real M2 money supply and real personal consumption expenditures occurs when real M2 growth is advanced by one quarter. Although real M2 growth underpredicted real consumer demand growth in the early 1990s and has overpredicted it in recent years, still, changing trends in real M2 growth have foreshadowed in the same direction changing trends in real consumer demand growth. Therefore, if the trend in real M2 growth is currently turning sharply lower, this could be a warning that the trend in real consumption growth will also be turning sharply lower in 2004. In fact, that slower trend in real consumption growth may already have started. Nominal retail sales have fallen in both September and October. We will be lucky to eke out real consumption growth at an annualized rate of 1-1/2% in the fourth quarter, versus the 6.6% growth posted in the third quarter.
Why has money growth slowed of late?
The popular answer to this is that households have made a portfolio shift out of bank deposits and money market mutual funds into stocks. I have no doubt that households’ demand for corporate equities has risen and their demand for M2 has fallen. I also have no doubt, however, that this is not the explanation for the abrupt decline in M2. If I purchase a stock from you, my M2 falls, but your M2 goes up by the same amount. So, there is simply a change in the ownership of M2, not a change in the amount outstanding. To better understand the reason for changes in the money supply, recall the Accounting 101 balance sheet identity: assets = liabilities + net worth. M2 represents a good chunk of the liabilities of the banking system. Assuming net worth does not change much in the short run, changes in the banking system’s liabilities will mirror changes in its assets - the banking system’s loans and investments, or bank credit. What has happened to bank credit growth recently? Chart 3 shows that, similar to M2, bank credit growth also has plunged. In the eight weeks ended June 11, bank credit grew at an annualized rate of 23.75%. In sharp contrast, in the eight weeks ended October 29, bank credit contracted at an annualized rate of 3.48%.
Why has bank credit suddenly contracted? I think it has something to do with the sharp slowdown in mortgage activity resulting from the backup in mortgage interest rates. Chart 4 shows that mortgage applications plunged starting in July. Banks have been major suppliers of funds to the mortgage market directly by granting mortgages and indirectly by purchasing mortgage-backed securities and securities issued by Fannie Mae, Freddie Mac, and other government sponsored agencies (GSEs). Chart 5 shows what has been happening to banks’ holdings of mortgages and mortgage-related securities. (Unfortunately, the Fed data on bank credit do not break out mortgage-backed and GSE securities. So, I had to use banks’ total securities holdings.) Their growth rate has been falling in step with the growth rate of total bank credit. So, the circumstantial evidence is very convincing (to me, at least) that the recent sharp slowdown in home mortgage activity is the principal reason for the recent sharp slowdown in M2 growth. To be sure, if households’ demand for M2 has dropped, then the negative impact on economic activity emanating from weak M2 growth will be partially mitigated. It is unlikely, however, that such a sharp contraction in M2 growth would be fully offset by a comparable rise in the velocity of M2.
What could lead to a quick resumption in M2 growth?
For starters, mortgage activity is unlikely to keep falling as rapidly as it has in recent months. So, this alone, should brake the rate of descent in bank credit and M2 growth. Also, the federal government will be a big demander of credit in the months ahead. Banks are likely to accommodate some of that demand, especially if the Fed keeps the funds rate at 1% for a "considerable period." With business inventories as lean as they are and with commodity prices on the rise, voluntary inventory building could set in. Thus, businesses may finally start to tap their local banks for funds again. Finally, if speculators expect the U.S. dollar to continue to depreciate, they will borrow greenbacks at rock-bottom interest rates and use these borrowed dollars to invest in money market assets denominated in Aussie dollars and euros. This, too, will lead to faster bank credit and money growth. This is what I expect. But if M2 growth does not pick up soon, then I may have to revise down my 2004 GDP forecast. Paul KasrielThe information herein is based on sources which The Northern Trust Company believes to be reliable, but we cannot warrant its accuracy or completeness. Such information is subject to change and is not intended to influence your investment decisions.
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