The article postulates that the "new" money supply variables are outside the purlieu and control of the Fed in stark contrast to the customary manner in which the Fed's policy tools have interacted with the traditionally defined aggregates in the banking system.
These nodi take on singular relevancy as the Fed addresses an economic crisic at the scheduled meeting of the FOMC on March 25th.
The morceau concludes that it is advisable, if not exigent, that the Fed adapt to the new environment proactively, rethink its traditional operating procedures and institute a more dynamic approach. Lacking that, the U.S. economy will surely be faced with:
The upcoming meeting of the Federal Open Market Committee on March 25 will be a watershed event on two counts: 1) it will probably endorse a 1/4 % hike in the Fed funds rate, a level which has prevailed since 01/96 and 2) it will shed light on certain phenomena which have intruded insidiously and disruptively on the smooth and unimpeded operation and implementation of Fed policy; cresive forces extant in the banking sector today which have worked to weaken and subvert the Fed's ability to control the money aggregates through the indirect management of required reserves. The implications of this vitiation are emphatic, but first, a bibelot of history.
At the close of 1990, the Fed removed the last vestiges of reserve requirements applicable to banking deposit liabilities in M2-only, and M3-only categories. Thenceforth, the 10% reserve requirement imposed on member banks' deposit bases would be relegated to only two categories of transactions accounts included in M1, demand deposits and other checkable deposits (ie. NOW accounts). Today, those two classifications comprise approximately $400 billion and $275 billion, respectively, for a total of $675 billion.
With the proliferation of financial innovation at the beginning of the decade, a myriad of creative and diverse financial instruments were introduced to the financial community, both institutional and private, which now populate the monetary landscape of the U.S. These new credit facilities (money market mutual funds (MMMF's), mutual stock funds, mutual bond funds, credit card and auto receivables funds, etc.), apart from MMMF's, are not included in the conventional measures of the monetary aggregates, M1, M2 and M3. This paradox holds particular irony given that it is the additional components included in the more comprehensive (and less observed) measures of the money supply that have largely supplanted traditional bank related sources of credit as the prepotent and preferred vehicles of debt. By way of quantification, as of year end 1996, M1 ~ $1.0 trillion, M2 ~ $4.0 trillion, M3 ~ $5.0 trillion, L (Liquid Assets) ~ $6.0 trillion and D (Flow of Funds) ~ $14.5 trillion. In the halcyon Fed days of yore, M1 and M2 were the proverbial heads of the monetary dog, with the other measures wagging idly in taillike resign. But all that changed in mid-1994.
To wit, the monetary aggregates stagnated in the early Nineties as the banking sector, led by the louche side of its family tree, the S & L Associations, worked out of the pangs of past profligacy. Recovery took hold and health returned to the banking industry as 1994 effloresced, but the anabasis was not led by the traditional M1 & M2 aggregates. In fact, for the period 06/94-12/96, M1 FELL -2.8%/annum, while M2 rose a modest +3.9%/annum. Meanwhile, M3 advanced by a whopping +6.3%/annum, with the broader measures L up a like +6.6%/annum and D smartly ahead by +5.56%/annum. In fact, while components of M2-only grew +17.6% for the period, M3-only components exploded +48.2%.
It is patently apparent that the growth in GDP during the last two years has been fueled by the ancillary venues of credit not included in the traditionally employed measures of the money supply. These other sources of credit act like a "parallel," or "secondary" mini-Federal Reserve, expanding and contracting credit outside and apart from the banking system and Fed control. It is no wonder that economist-savants have been nonplused to explain why the velocity of M2 with respect to GDP has behaved in such an anomalous fashion, particularly during the 1990-1992 span, wherein it rose during a period of declining interest rates, instead of following historical precedence which suggested that it should fall. Clearly, the dynamics of monetary management had and have changed radically. Fed policy can no longer be reserve driven, whether directly through reserve-targeting, or indirectly through Fed funds rate-pegging. All ancillary forms of credit creation, especially those categories included in the L-only and D-only categories, subvert the Fed's ability to control the system through reserve management largely because these "parallel" conduits of credit wend their willful ways on expanding GDP, thus burgeoning velocity as measured by the more traditional aggregates. Simply raising Fed funds a notch does not thwart the agency of their power. Why? Consider the following: With the remaining CD deposit liability category removed from reserve requirement in 1990, only the $675 billion in transactions accounts (demand deposits) and OCD's (other checkable deposits) currently are subject to the 12% reserve requirement and, of course, both are M1 deposit liabilities. Therefore, $81 billion (12% X $675 billion) is the sum total against which a hike in the Fed funds rate operates, a number, which to put in proper prospective, is an order of magnitude not dissimilar to Bill Gates' mark to market holdings of Microsoft. But even presuming the bump in rate has the intended effect of contracting nominal reserves, a real leap of faith considering that the Fed recently ADDED about $6 billion in permanent reserves to the system through a series of coupon passes in a bevy of tranches, that effect will be registered as against only two classifications of deposit liabilities, both of which are at best secondary to banks' deposit gathering priorities. Primary, or "high powered" deposits are, of course, CD's which are M2 and M3 classifications. What is more, since they peaked in 02/94 at $60.8 billion, total reserves have declined to $49.4 billion as of 02/97, just about where they were five years ago in 04/92.
The reality is that while the economy has strengthened considerably since 06/94, both M1 and its associated reserves have declined. Rhetorical questions: What force and effect on slowing the forward economic momentum of the U.S. economy will the removal of reserves from an aggregate that is already in decline have? What value will be imparted to the Fed's stated objectives by slowing, or more accurately, accelerating the decline of an aggregate that has clearly evinced its disjunction from and non-participation in the monetary growth requirements of the U.S. economy?
Plain and simply, the Fed has no control over the critical mass of money and "near money" that today injects sinew into the growth of GDP. That implies that the Fed is at the mercy of velocity, a turnover of money which is empowered by a mastodonic deposit base $10 trillion strong and wholly outside the ambit of the banking system. To believe that the Fed will control this juggernaut by removing a few billion dollars from a wasting aggregate suspends disbelief and is, in fact, pure artifice, a thewless and meaningless beau geste.
So what is a poor Fed to do? Under the presumption that Fed policy, by innovation, is no longer reserve driven, either directly through reserve targeting, or indirectly through rate-pegging, Alan Greenspan and Company must seek to tame the bugbear over which it has no direct control, velocity; the surrogate of traditional bank credit creation. Velocity is undaunted by small incremental upticks in the Fed funds rate (e.g. 25 basis points), the kind for which Greenspan has become renown. No, velocity needs to be bludgeoned by an absolute level of rate and if required, substantial increases in Fed funds in order to achieve that level.
There is no predetermined formula by which the Fed may know how much that rate increase must be in order to quell inflationary forces when stresses begin to build in the economic infrastructure. Suffice to say that the period preceding the Fed's last foray into Fed funds rate increases was characterized by an economic environment not substantively different from the one with which we are now faced. One particularly poignant reportage during that prior period was the 01/28/94 Department of Commerce announcement that GDP for the 4th quarter of 1993 was up 5.9% (later adjusted upward to +7.5%), largely accounted for by net exports (sound familiar?), even as the implicit price deflator came in at a docile 1.3% ( sound more familiar?) and unemployment hovered at 6.5% (contrasted with the current 5.3%). Nevertheless, it would be understatement to suggest that the Fed was somewhat "surprised" when it found it was constrained to lift the Fed funds rate by 300 basis points, from 3% to 6% in the short time span of one year, before economic deceleration took hold.
In the upcoming round, the Fed will be at a crisic. It will find that it must attack velocity by gibbeting it into submission with the widdy of a meaningful increase in short term interest rates to a higher critical level. History mandates that it be implemented with incisiveness and dispatch. Whether that policy imperative ultimately takes the Fed funds rate to 6% as in 1994, or higher, is unknown at this time. What is certain, however, is that merely nudging the rate by a paltry 1/4% is tantamount to doing nothing at all in the new monetary order. Market participants are well advised to take heed. Neither stocks, nor bonds tend to cotton kindly to any Fed tightenings, much less those that precedency suggests will require greater snugging increments than is currently bruited by the street.
March 15, 1997