Does money matter in sustaining the nascent recovery? That's the critical question posed by the unusually sluggish behavior of the money supply, which normally grows rapidly at the onset of an upswing. At last count in late July, M2, the Federal Reserve's favorite monetary aggregate, was virtually stagnant-up only 2.8% over its year-earlier level-compared with an average 12-month growth rate of 7.2% at the start of the previous five recoveries.
Although the Fed eased slightly in early August, it claims to be unperturbed. As Robert Parry, president of the Federal Reserve Bank of San Francisco, recently commented, the relation of M2 "to economic activity in the short run is highly variable." The prevailing view at the Fed seems to be that recent changes in the financial system and in investor behavior are causing monetary measures to underestimate the availability of liquidity in the economy.
The biggest factor affecting money measures is the drastic downsizing of banks and thrifts. Economist Martin Barnes of Bank Credit Analyst estimates that highly leveraged transactions and commercial real estate accounted for 40% of the increase in bank lending during the second half of the 1980s. The drop in loan demand associated with the purging of these excesses, he notes, implies a shrinkage of bank assets accompanied by a lessened need for deposits. The upshot has been an outflow of funds from banks into savings instruments-bond and equity funds, Treasury securities, and the like-that aren't part of the basic money supply.
Economist Robert DiClemente of Salomon Brothers Inc. describes how the Fed's shift toward ease has tended to foster this process. With the Fed funds rate down by about 30% over the past year, the money-market yield curve-the gap between short- and long-term interest rates-has steepened considerably. But the yield curve among bank deposits has flattened as banks and surviving thrifts have sought to boost profit margins by holding down the rates they're willing to pay for time deposits.
The result: Confronted with the far more attractive returns available outside the banking system, households have been moving aggressively into open-market instruments-investing more in bond funds over the past four months, for example, than they did in all of 1990. In sum, monetary growth has slowed because of portfolio shifts among individual savers.
What's more, DiClemente notes that the most liquid components of M2-currency, checkable deposits, and passbook savings accounts-have grown at a healthy 9.7% annual rate over the past six months. "Since these are the instruments that can be drawn down quickly to support a pickup in spending," he says, "the trend suggests that monetary ease has been effective."
Such arguments seem particularly compelling to a Fed that has a history of panicking in the early stages of past recoveries and stimulating too much. But the acid test will be the behavior of the economy itself. As the Fed's latest nudging of the funds rate suggests, the pressure to ease aggressively could reach a critical mass if money growth stays slow and the recovery appears to be faltering.