The Fed's Y2 K Hangover

Why it could jack up rates

Remember the money supply? Although Federal Reserve policymakers pay little attention to its fluctuations these days, many economists are casting a wary eye on the latest money numbers--especially the broad M3 monetary aggregate, which includes currency, checking accounts, money-market funds, and savings deposits, as well as large CDs and other bank liabilities.

One concerned observer is Paul L. Kasriel of Chicago's Northern Trust Co., who notes that in the eight weeks ended Dec. 20, M3 growth soared to a 22% annual rate, the highest in at least 15 years, while bank-credit growth hit a 23.4% annual clip. This dual pattern, he says, suggests that "Fed Chairman Alan Greenspan has been inadvertently spiking the monetary punch rather than taking the punch bowl away."

The conventional wisdom, observes Kasriel, is that the explosive growth of M3 is basically a Y2K phenomenon, reflecting the public's desire to hold a lot more currency as the calendar flipped to the year 2000. But while people's demand for currency did shoot up at a 21.3% rate in recent months, he points out that most folks obtain cash by running down their checking and savings deposits, which are also part of the M3 money supply. "Changing the composition of M3," he says, "doesn't necessarily increase its growth rate."

To be sure, money growth could accelerate if the public's currency withdrawals ate into the banks' required reserves or if the banks aggressively increased their holdings of vault cash to meet anticipated public demand. In fact, the Fed did add reserves to the banking system in recent months to offset such needs and keep the banking system on an even keel.

Such defensive operations alone, however, are hardly a reason for monetary growth to explode. From Nov. 1 to Dec. 20, as M3 before seasonal adjustment shot up $245 billion, its currency component rose only $23 billion and surplus vault cash just $13 billion.

Thus, the key factor behind M3's heady growth appears to be the Fed's accommodation of the surge in bank lending--which has exceeded even the soaring bank loan growth in late 1998, when credit market problems in the wake of the Russian default and hedge-fund debacles forced corporations to turn to the banks for funds. And this time around, notes Kasriel, far faster growth is being posted by consumer and real estate loans than by commercial and industrial loans. Even margin debt has been skyrocketing.

In sum, Kasriel thinks the recent explosion in M3 has more to do with strong credit demands in the economy than with Y2K concerns. And that suggests that the Fed will be far more aggressive in pushing up rates in coming months than many people expect.

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