Does The Shrinking Money Supply Spell Trouble?Christopher Farrell
The size of the shift out of bank deposits and certificates of deposit into other investments is stunning he rumblings of economic strength are there, but so is the unsettling evidence of mounting weakness. Auto sales are stalling, and layoffs are picking up. Banks aren't lending, and battered Citicorp has eliminated its dividend. Most worrisome to some economists is the striking slump in the nation's money supply. A broad measure of money called M2, which includes everything from checking-account balances to $100,000 certificates of deposit, has been shrinking at a 1% annualized rate over the past three months, vs. the 7% average growth rate of the past five upturns in the business cycle.
Some economists -- including Michael J. Boskin, chairman of the Council of Economic Advisers -- worry that the shrinking money supply could be signaling anemic growth. Others are even more pessimistic, arguing that "this very slow money growth could drag the economy back down into a recessionary environment," in the words of John B. Trammell, economist at A. Gary Shilling & Co. Federal Reserve Board Chairman Alan Greenspan, who insists that the recovery will soon pick up steam, calls the relationship between M2 and gross national product "one of the most enduring in our financial system." So is it time for businesses and consumers to brace for the recession's second coming? Probably not. "Structural financial changes account for much of the weakness in M2," says Stephen Slifer, economist at Shearson Lehman Brothers Inc. The traditional relationship between M2 and GNP doesn't hold anymore. Right now, the money supply is sending out false economic signals, agrees Robert Giordano, director of economic research at Goldman, Sachs & Co.
OUT OF SYNC. This recession has been anything but typical, and that explains why the money supply and the economy are no longer moving in lockstep. In the past, the economy sank after a sharp rise in inflation forced the Fed to push interest rates higher. The tight money cooled off inflation but took the economy down as well. This time the economy was brought down by the financial excesses of the 1980s, not by tight Fed policy. Those excesses produced a commercial real estate glut, a shaky banking system, and a bankrupt thrift industry.
So the fall in M2 is a phony sign of impending economic disaster. What is happening is that consumers are pulling their money out of the troubled banking system (counted in M2) and switching it into bonds and stocks (not counted in M2). And more businesses are financing their activities outside the banking system, too. "We're in uncharted waters," says Jerry Jordan, economist at First Interstate Bancorp.
Indeed, Fed easing itself may be largely responsible for sluggish M2 growth. In trying to spark a recovery, the Fed has lowered the federal funds rate nine times over the past nine months -- to 5.25% from 7.5%. Other short-term rates have followed, especially the rates banks and thrifts pay on their certificates of deposit. Thus, investors are moving money out of CDs paying a measly 5% and seeking higher returns in bond and stock investments. The result: M2 growth shrivels.
The size of the shift out of bank deposits and into other investments is stunning. In September, the net inflow into bond funds reached $90 billion at an annual rate, a good part of that coming out of the banking system. The inflow could swell even further as some economists estimate that $100 billion in CDs under $100,000 mature in October. The lower short-term interest rates go, the more funds could flow out of bank deposits and into the markets, further shrinking the money supply.
MALLS AND OFFICES. The collapse of the thrift industry has also led to the decline in M2. When the government takes over failed thrifts, these troubled institutions usually lose depositors. But Resolution Trust Corp., the overseer of the thrift bailout, needs funds to finance all the shopping malls, office buildings, and securities it inherited from the thrifts. To make up the funding shortfall, Resolution Trust raises money by selling government-backed bonds, which are not included in the money supply. "Replacing the private deposits with Treasury debt will shrink M2," says Lyle E. Gramley, chief economist of the Mortgage Bankers Assn. and a former Fed governor.
Add it all together, and a more robust money picture emerges. The thrift bailout and net inflows into bond mutual funds account for almost all the shortfall in M2 over the past several months, according to calculations by Goldman's Giordano. By his arithmetic, "adjusted M2" has been growing by at least a 6% annual rate over the past six months--near the top of the Fed's target band of 2.5% to 6.5% growth. By contrast, unadjusted M2 has been crawling along at a feeble 2% rate.
To be sure, the economy may need more stimulus to get it moving faster. But the decision to lower interest rates should come from what is happening to the real world of housing, employment, incomes, and inflation, and not from the M2 money supply. That measure is far too suspect to serve as a guide for Washington's policymakers.