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Fed’s Forsaken M3 Money Gauge Points to Deflation: Chart of Day

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May 24 (Bloomberg) -- A measure of the U.S. money supply, created but abandoned by the Federal Reserve, has turned negative in the past year and signals disinflation or outright deflation, according to economists who track the figure.

The CHART OF THE DAY shows M3 has shrunk 5.4 percent in the past year, an indication the economy may face deflationary pressure as fewer dollars chase the same amount of goods, according to economists Paul Ashworth and Paul Dales at Capital Economics Ltd. in Toronto. They began compiling a measure of M3 after the Fed discontinued it in 2006.

“Sharp falls in the money supply tend to go hand in hand with very, very low rates of inflation if not deflation,” Dales said. The decline in M3 “suggests there is perhaps greater downward pressures on inflation than M2 suggests.”

The core inflation rate rose last month by 0.9 percent from April 2009, the smallest increase since January 1966, after a 1.1 percent year-over-year advance the prior month.

The Fed reports two measures of the money supply each week. M1 includes currency held by consumers and companies for spending, money in checking accounts and travelers checks. M2 adds savings and private holdings in money-market mutual funds. M3 encompassed M2 along with large time deposits, repurchase agreements, Eurodollar accounts and institutional money-market mutual funds.

M1 and M2 have risen as the Fed boosted bank reserves by creating new money to purchase up to $1.43 trillion in housing debt.

M3 has fallen along with bank lending, as banks chose not to use the increase in reserves as leverage for new loans. Many types of account balances have declined, including those tracked by M3. One such component, institutional money fund balances, fell to $1.94 trillion in April from $2.52 trillion a year ago.

The Fed stopped measuring M3 in 2006, saying it “does not appear to convey any additional information about economic activity that is not already embodied in M2 and has not played a role in the monetary-policy process for years.” The Fed said the costs of collecting the measure outweighed the benefits.

To contact the reporter on this story: Joshua Zumbrun in Washington at jzumbrun@bloomberg.net.

To contact the editor responsible for this story: Christopher Wellisz at cwellisz@bloomberg.net

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