Barbara Bennett

English

Research Papers in Economics

February 12, 1982
New Measure of M-2
.In this era offinancial innovation,the Federal
Reserve needs to monitorvarious monetary
yardsticks toensure thatsuch yardsticks mea-
sure whatthey are supposed to measure. To
this end, the Fed made several changes re-
cently in the broad M-2 and M-3 aggregates
to help provide a more consistent and mean-
ingful measure ofthe stock ofassets that are
held fortheirease ofconversion into transac-
tion balances. The changes, on balance,
involvedonlyabout$16billionoutofan M-2
measure thatapproaches $2 trillion in size
-nevertheless, they represented an impor-
tant step in the Fed's continuingeffortto
improvethe measurementofmoney.
The M-2 aggregate basically includes cur-
rency, transaction (checkable) deposits, and
other consumer-type balances-including
money-marketfund shares, travellers
cheques, and small denomination (less than
$100,000) time certificates atdepository
institutions. (M-2 also includes a moderate
amountoflarge denomination overnight RPs-
and Eurodollars.) To retain this basic con-
sumerorientation, the Fed lastweek removed
from M-2themoney-marketfund shares held
onlyby institutions, butadded retail repur-
chase agreements (RPs) to the small denom-
ination-timedeposit componentofM-2. This
article reviews the reasoning behind those
actions, and raises some general issues
regarding the measurementofmoney.
Retail RPs
Retail RPs are securities sales-with agree-
mentto repurchase-in denominationsof
less than $100,000 with maturities of less
than 90 days. Although they have been in
existenceforanumberofyears, retail RPs did
notbegin growingto any significantextent
until late spring 1981, when a numberof
depository institutions began to offerthem in
competition with money market funds and
later in connection with their promotion of
the newtax-exemptAll-Savers Certificates.
Thus, between December 1980 and Septem-
1
ber1981, retaiI RPs jumpedfrom $1 .2 biIIion
to $13.3 billion. Indeed, outstandingsdeclin-
ed only slightly belowthat level duringthe
final quarterbf 1981, even though banks no
longersold retail RPs as a means ofbringing
in All-Savers money.
Untillastweek, retail RPs were included in
the broaderM-3 aggregate, along with term
RPs in denominations of$100,000 ormore.
The Fed then decided to make a shift, pri-
marily because retail RPs, unlike large term
RPs, tend to be close substitutes forseveral of
the components ofM-2-such as passbook
savings, small-denominationtimecertificates
and money-marketfunds. In fact, in offering
retail RPs, many banks and S&Ls have gener-
ally set minimum investment requirements
and yields that are akin tothose ofmoney-
marketfunds.
Ifthe change had been in effectduring 1981,
M-2 growth for the yearwouId have been
more rapid, particularlyduringthe summer
months when retail RP growth was greatest
(see chart). The M-2 monthlygrowth rates
(with and without RPs) diverged significantly
in July, August and September, butthen con-
verged again in the following months. As
households adjusted their portfolios in re-
sponse to heavier promotion ofretail RPs,
theymayhaveshifted funds outofM-2(pass-
booksavings, money-marketfunds, etc.), and
thus restrained growth ofM-2.Witbthecom-
pletionofthe initial adjustment, however, the
retail-RP impactbecame minimal, even
though attimes householdscontinuedtopur-
chase retail RPs at a fairly rapid pace.
Institutional MMFs
While shifting retail RPs from M-3 onlyto
M-2, the Federal Reserve last week made an
opposite shiftfor shares ofmoney-market
funds thatcater to institutional investors.
These funds, unlikegeneral-purpqse (house-
hold) funds, require substantial minimum
initial investments, ranging as high as
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Opinions expressed in this newsletter do not
rl(?cessarilv reileet the views of the managernent
of the Federai Rcserve Bank of San Francisr:o,
()t" crt the Board cd Covernors of the Federal
Reserve System.
$250,000. These funds are attractive to insti-
tutional investors for avarietyofreasons-all
related primarily to their attractiveness as
investments, rather than to their attractive-
ness as cash-managementtools. Thus,
because they are substitutes for large certifi-
cates ofdeposit and large term RPs, they
appear to fit better into the broader M-3 ag-
gregate than into the M-2 measure.
Institution-only MMFs permit small- to
medium-sized firms to invest in a diversified
portfolio ofmoney-market instruments, with-
outthe large investmentthatthey wouId need
ifthey were to invest directly in a diversified
portfolio. Second, because oftheir large size,
MMFs can realize economiesofscale in over-
head costs that small- and medium-sized in-
stitutions cannot obtain on their own. Third,
institution-only MMFs offer shareholders an
asset-valuation method that holds the indi-
vidual share value constant over fairly wide
fluctuations in interest rates. (In other words,
these funds attract shareholders thatwantto
avoid capital losses in an accounting sense.)
Finally, with money-fund managers actively
managing the average maturity oftheir port-
folios according totheir interest-rate expecta-
tions, MMF yields can frequently exceed the
yields obtainable through direct investment,
particularly during periods offalling rates.
Institutional investors, unlike households,
have other cash-management tools available
to them (e.g., overnight repurchase agree-
ments), so thatthey tend to view MMFs pri-
marilyas alternativestodirectmoney-market
investments. As a result, the monthly growth
rates ofinstitution-only MMFs in recent years
have tended to reflect changes in the spread
between MMF yields and yields on money-
market instruments. With the inclusion of
these funds in M-2, M-2 growth likewise has
shown a somewhat inappropriate sensitivity
to money-market yields, given the nature of
M-2 as a more liquid measure than M-3.
Since 1979, the growth ofthe two M-2 mea-
sures-with and without institutional
MMFs-has at times diverged significantly
(see chart). Furthermore, the periods when
the two growth rates have differed the most
have also been the periods when the spread
between money-fund yields and other
money-marketrates has widened substantial-
ly (in an absolute sense). With the exclusion
of institution-only MMFs, M-2 growth would
have been lower in every year since 1979
and would have been less volatile as well.
The growth in general-purposefunds, by con-
./
trast, does notdisplay the same sensitivity to
changes in yield spreads (see chart). Their
growth instead appears to be more closely
correlated with the overall/eve/ ofinterest
rates, so that in this respect they behave like
the six-month money-market certificates and
30-month small-savers certificates. Hence, it
seems appropriate to keep general-purpose
funds in M-2, while excluding institution-
only money funds.
IRA/Keogh Deposits
The new Individual Retirement Accounts
(IRAs) and the similar Keogh accounts repre-
sent another recent institutional change that
may affect the behaviorofthe monetary ag-
gregates, as the public adjusts its portfolioto
achieve its desired holdings ofthese new
accounts. Because these funds are held pri-
marily in consumer-type time deposits, they
are presently included, for the most part, in
the small-denomination time-deposit
componentofM-2. However, in view ofthe
tax-law changes that expanded eligibility for
these accounts, as well as the decision ofthe
Depository Institutions Deregulation Com-
mittee (DIDC) to allow depositories to offer
such accounts Without interest-rate ceilings,
IRA and Keogh accounts are likelyto grow
rapidly as depositors shift funds from other
long-term investments and/or increase their
savings rate to take advantage ofthe tax
benefits they offer. .
These changes in the behavior ofIRA and
Keogh deposits may well mean that the
various componentsofM-2will no longerbe
similar in nature. First, since substantial pen-
alties are involved in spending the funds des-
'ignated as IRA/Keogh contributions priorto
23
SChange
16!G.:neral Purpose j14
~: MMF Ylel~ • ~ 12
12 ./ \ !\A. 10
10 I I Y\ ~ 6
-0 G.=neral _•••_ I \, I\
:lijr
7 ;;'1 \I ~. :
2 \~\\\ ' .~ /' 1/ \ f'r\ (' \ 2 o \ I \ I \
'\ I \ ..... ,' \ ,~
-2 \{ " " \, '. / Yield 0
\..: " ~Spread'
-4 1980 1981 -2
•(MMF-CD Rate)
Barbara Bennett
The necessity ofa thorough reevaluation of
the aggregates is, to a certain extent, an
empirical question. Before considering such
a major undertaking, analysts should have
evidence ofsignificant growth in deposit-
sweeping arrangements and other alterna-
tives to traditional transaction instruments.
Yet ironically, the numberofsuggested ad
hoc adjustments might provide evidence in
itselfofthe need for a major reevaluation.
Chart 3
between those financial instruments that are
used primarily for transaction purposes and
those that are not. Hence, minordefinitional
adjustments are possible (and advisable)
without a change in the basic meaning of
each aggregate.
Others might argue, however, that incre-
mental adjustments to the aggregates cannot
adequately capture the fundamental changes
that are occurrir{g in the way the public
chooses to hold wealth and handle transac-
tions. Deposit-sweeping arrangements, loop-
hole accounts, and even retail RPs are
blurringthe distinctions between M-1 types
and M-2 types ofassets. The principle under-
lyingthe redefined aggregates is substitut-
ability-like assets are combined at each
level ofaggregation. The narroweraggregates
should comprise only those assets that are
closest substitutes as pure transaction
balances. Thus, the narrow M-1 measure in-
c1udesdemand deposits and NOWaccounts,
which share many ofthe same liquidity char-
acteristics-butexcludes money-market
funds, which do not have exactly the same
characteristics. Yet some portion ofthe
public is clearly using money-marketfunds as
transaction accounts, through deposit-
sweeping arrangements orotherwise. Adhoc
adjustments to the present aggregates which
add or remove a particular asset category
cannot capture this phenomenon very well.
2
Percent Chart 2
4 Yield
Spr1.ad· Growth
\. Dlf~rence"
.4 1960 ~ 1961
·(MMF·CD Rate)
"Difference in M-2 growth
with and without Institution-
only MMFs
M·2Growth -1--' -5 LJ..llJ.
19
l..LJ
6
L.U.
O
J.U.U.l..U
19
L.U.
61
.l..l.U.J
retirement age (59Y2L these deposits are
likely to be very long-term in nature, rather
than sybstitutes for such M-2 components as
money-market and small-saver certificates.
Second, since depositories nowoffer IRA/
Keogh accounts at market rates-and with
expanded eligibility-those accounts com-
pete closely with products offered by non-
depository institutions (such as life-insurance
and securities firms) which are not included
in M-2. But the limited experience with such
accounts afterthe recentchanges has made it
difficulttogaugetheir impactonthe behavior
ofthe aggregates.
There remains a broader question aboutthe
approach used in changing the definitions of
the monetary aggregates. Specifically, ifthe
definitions ofthe aggregates have become
outmoded as aresultofrecentfinancial inno-
vations, is itenough to make minor incre-
mental adjustments-the approach now
used-or is athorough reevaluation ofthe
basic definitions necessary as well?
Those favoring an incremental approach
would argue thatthe changes in financial
instruments are neitherso far-reaching norso
rapid as to call into question the basic integ-
rity ofthe concepts underlyingthe monetary
aggregates. In otherwords, wecan still distin-
guish, on the basis oftheir characteristics,
Implicationsofchanges
Altogether, the inclusion ofretaiI RPs and the
exclusion ofinstitution-only MMFs has prob-
ably improved M-2 as a measure ofthe stock
ofnear-monies. The summerupsurge in retail
RPs wouId have led tofaster M-2 growththan
what was actually observed. On the other
hand, the removal ofinstitution-only MMFs
would have reduced the year-over-year
growth rate ofM-2. M-2 growth would also
have displayed somewhat less sensitivity to
rates on financial instruments that are in-
cluded in the broader aggregates. Overall,
however, the impactofthese two changes
would have been small in 1981, reducing
M-2 growth from 10.4 percentto 9.9 percent
(December-December).
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.4'lnn • uo8aJO • E'pE'i\aN • 04E'PI
E'!UJoJ!IE':::> • E'UOZ!JV' • E')jSE'IV
BANKING DATA-TWELFTH FEDERAL RESERVE DISTRICT
(Dollaramountsjn millions)
SelectedAssets and Liabilities
___~~£~.~~l~!Janks
Loans (gross, adjusted) and investments*
Loans (gross, adjusted),• ._.._total#
Commercial and industrial
Realesta~
Loans to individuals
Securities loans
U.s~.TreasurYsecurities*
Othersecurities*
Demand deposits,- total#
Demand deposits --adjusted
Savings d~posits:"- total
~.., Time deposits --total#
Individuals/part. &corp.
(Large negotiable CD's)
Amount
Outstanding
1/27/82
156,597
135,315
41,566
55,992
23,707
1,912
6,167
15,115
38,472
27,460
30,211 .
90,845
81,830
36,556
Change
from
1/20/82
149
36
108
80
5
- 126
136
23
-1,926
- 582
- 543
793
796
603
.I CC))~~Y~\ill~Jrd( \ill~C£
~CC)) 24I\ill~ em
@j)\Jr@~@CQI TI~Jr@~@d(
~ \ill~ m~,JJ\2?dI ~@ IS{I ~,JJ\2? ~<§ ~CQI
Change from
year ago
Dollar Percent
9,473 6.4
10,764 8.6
4,576 12.4
5,206 10.3
55 - 0.2
425 28.6
633 '- 9.3
637 - 4.0
1,629 - 4.1
- 1,609 - 5.5
1,208 4.2
14,051 18.3
14,690 21.9
6,266 20.7 :
WeeklYAverages'
ofDaily Figures
Memneroank'Reserve Position
Excess Reserves (:+)/Deficiency (-)
BorroWings
Net free re5eeVes(+)/Net bol'rowed(-)
Weekended
1/27/82
69
171
- 102
Weekended
1/20/82
83
21
62
Comparable
year-ago period
17
237
220
"',Excludes trading accountsecurities-
# Includes items notsh()wnseparately.
Editorialcornments maY beaddressed totheeditor (William Burke) orto theauthor •••• Free copies of this
andother Federal Reservepublicationscanbeobtained bycallingorwritingthePublicInfonnation Section,
Federal Reserve BankofSan Francisl:o, P.O. Box 7702, San Francisco 94120. Phone (415) 544-2184.

New measure of M-2

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New measure of M-2

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Research Papers in Economics