Reporting Focus from the June 2005 Edition of the SGS Newsletter

Last month’s "Reporting Focus" explored some of the relationship between money supply growth and economic activity. Specifically noted was the use of the broadest money measure (M3) in the SGS Early Warning System, where declines in inflation-adjusted annual growth in money, beyond a certain fail-safe point, always are followed by an economic contraction. This month, SGS review will briefly some general background to the Federal Reserve’s money stock measures.
The Board of Governors of the Federal Reserve System publishes week1y measures of the nation’s money stock on Thursday afternoon at 4:30 Eastern time. The data published are for the week ended the Monday of the prior week.
The Fed has been publishing information on domestic money supply since the central bank’s founding in 1913. More extensive, earlier data and arguments as to certain historical relationships between money and the economy also can be found in Milton Friedman and Anna Jacobson Schwartz’s classic "A Monetary History of the United State 1867-1960."
What has been defined and reported as money supply has changed meaningfully over time. Such has reflected the varying nature of the financial markets, the banking system and the Fed. Money growth, regardless of definition, often, though not always, has been a driving force behind economic activity and inflation. Often, though not always, changes in money growth have reflected Federal Reserve monetary policy, overt or covert. The best relationship established between money growth and business activity is that contracting money supply and its resulting liquidity squeeze will throw an economy into recession.
Here’s a summary of the key monetary aggregates. The three major money measures are M1, M2 and M3. Each successive measure includes the prior measure (M2 includes M1, M3 includes M2), and each successive measure includes less-liquid assets than the one before.
M1 includes currency in circulation (outside the U.S. Treasury, Federal Reserve Banks and the vaults of commercial banks, savings banks, credit unions, etc.), checking accounts, travelers checks and other near-cash deposits.
What is unusual about and distorting to the M1 measure is that it includes U.S. currency outside the United States. The latest money supply report shows a seasonally-adjusted $706 billion of currency, accounting for more than half of M1, but a fair portion of that is abroad, fueling underground economies, serving as a store of wealth, etc. Accordingly, aggregate M1 changes do not always reflect what is going on in the U.S. economy, the U.S. financial markets or actual currency in circulation in the United States.
M2 includes M1 plus savings, small time deposits and retail money funds. Traditionally, growth in inflation-adjusted M2 has been touted as the best leading monetary indicator to economic activity. It was incorporated into the government’s index of leading economic indicators, which was taken over by the Conference Board in recent years.
In contrast, our historical modeling during the last two decades found the broadest liquidity measure to be the best predictor of economic activity. That used to be the L (liquidity) measure, which included M3, but M3 is the broadest measure available today from the Fed.
M3 includes M2 plus large time deposits, institutional money funds, repurchase agreements and certain Eurodollar deposits. It is M3 that is used in the SGS Early Warning System, as discussed last month.
Current money supply reporting is described in some detail at the Fed’s website as to its H.6 release and supporting documents: Board of Governors of the Federal Reserve System.