A look at the recent acceleration in M2, examining evidence that its velocity has stabilized around a new trend, analyzing the usefulness of money in monetary policy deliberations, and highlighting some of the pitfalls of ignoring money growth.Money supply ; Monetary policy ; Velocity of money

John B. Carlson

English

Research Papers in Economics

As has been the case for several years,
the 1997 ranges for M2 and M3 were set
against a backdrop of uncertainty about
the stability and predictability of their
velocities. ... Movements in [M2] velocity
have become more predictable over the
past couple of years. This recent evi-
dence of stability, however, covers only a
relatively brief period, and its durability
remains uncertain. In these circum-
stances, the Committee has opted to con-
tinue treating the ranges as benchmarks
for the trends of money growth consistent
with price stability rather than as short-
run targets for policy. Meanwhile, the
actual behavior of the monetary mea-
sures will be monitored for as much
information as it may convey about
underlying economic developments.
— Federal Reserve Board
February 26, 19971
W hen things appear to be working
well, there’s a natural reluctance to tink-
er. For several years now, the policymak-
ing arm of the Federal Reserve System,
the Federal Open Market Committee
(FOMC), has conducted monetary policy
in a framework in which money growth
plays no formal operational role. Since
the summer of 1993, when Federal Re-
serve Chairman Alan Greenspan reported
that M2 had been de-emphasized, eco-
nomic outcomes have been quite favor-
able. Output growth has accelerated to an
average rate of about 3 percent over the
period, and inflation has fallen to nearly
2 percent thus far in 1997. Moreover, the
“core” rate of inflation—the Consumer
Price Index (CPI) less food and energy—
rose 2.2 percent over the 12-month peri-
od ending last September, the smallest
annual increase since 1966. Such results
do not inspire a significant change in the
way policy is implemented.
Although the FOMC specifies annual ob-
jectives for the monetary aggregates M2
and M3, they are not accorded the status
of targets.2  Over the past three years,
these ranges have been set at 1 to 5 per-
cent for M2 and 2 to 6 percent for M3.
Markets thus far have little reason to be-
lieve that growth outside these bounda-
ries would, by itself, motivate the FOMC
to change the intended fed funds rate. In-
deed, M2 has been at or above the upper
end of its provisional range over much of
the past two years, but the Committee
has raised the federal funds rate only
once (in March of this year; see figure 1).
Nevertheless, evidence continues to
accumulate that M2 is again behaving
consistently with historical experience.
One manifestation is that the velocity of
M2—the ratio of nominal GDP to M2
—appears to have stabilized around a
new trend. A key implication of a stable
velocity is that an acceleration in M2 to
some higher-than-warranted growth rate
risks an acceleration in inflation some-
where down the road. This raises two
important questions for policymakers:
Should the FOMC place more emphasis
on money growth? And, if targeting M2
is not feasible in the near term, what
alternative role might the aggregate
serve in the formulation of monetary
policy? To address these questions, this
Economic Commentary examines evi-
dence that a stable relationship is
November 1997
Federal Reserve Bank of Cleveland
Accelerating Money Growth: 
Is M2 Telling Us Something?
by John B. Carlson
In the late 1970s and early 1980s, the
FOMC built its fight against inflation
around monetary targeting. The mon-
etary aggregates’ role in the policy-
making process was downgraded in
the early 1990s, when M2’s velocity
began to rise much more quickly than
past experience would have predicted.
Although evidence is accumulating
that M2 has now stabilized into a pat-
tern more consistent with its historical
performance, the data are too limited
to recommend a resumption of mone-
tary targeting.  But ignoring the sharp
acceleration in M2 over the last year
and a half would be equally unwise.
ISSN 0428-1276reemerging, analyzes the usefulness of
money in policy deliberations, and high-
lights some of the pitfalls of ignoring
money growth.
n n The Demise and 
Reemergence of M2 
Although the FOMC announced in 1993
that it had reduced its reliance on M2,
the aggregate’s role had been slowly
diminishing for several years as evi-
dence accumulated that its velocity was
increasing much more rapidly than past
experience would have predicted (see
figure 2). Historically, M2’s velocity has
varied directly with its opportunity cost,
although velocity has drifted upward
over time.3  This comovement largely
reflects the public’s demand for liquid
balances, which is determined primarily
by the level of spending and the forgone
yield of holding fewer liquid assets—
that is, the opportunity cost of money.
As the opportunity cost of M2 rises,
individuals tend to hold fewer M2 assets
relative to a given level of spending.
Consequently, M2 velocity increases.
The stable velocity pattern broke down
in the early 1990s largely because of a
confluence of factors that depressed the
public’s desired holdings of depository
instruments, which make up the biggest
share of M2. These factors included the
contraction of the thrift industry, a large
spread between short- and long-term
interest rates, and innovations that re-
duced the transaction costs associated
with bond and stock mutual funds,
thereby increasing the accessibility of
capital market instruments to the ordi-
nary household.4
The thrift industry’s contraction was
driven mainly by its need to rebuild cap-
ital positions that had been diminished
by a large number of nonperforming
loans. Troubled depositories were forced
to tighten lending standards, which lim-
ited their loan expansion. In turn, they
found little need for funds and hence did
not price deposits attractively. At the
same time, long-term securities such as
bonds were yielding significantly higher
rates than were short-term instruments.
The wide divergence between long- and
short-term yields acted as a catalyst for
the development of bond mutual funds.
More precisely, the mutual fund industry
employed marketing strategies that en-
abled ordinary households to learn about
bond funds and their relatively attractive
yields. As a result, many Americans
chose, for the first time, to move some 
of their wealth from M2 deposits into
bond funds. It now appears that for
many of these people, bond funds have
become a permanent part of their portfo-
lios, supplanting bank CDs (previously
the only major form of financial wealth
for most households). This shift perma-
nently reduced the level of deposits rela-
tive to economic activity such that the
trend of M2 velocity ratcheted upward
rather abruptly.
With the improved health of the thrift
industry and the return of the yield struc-
ture to a more typical state, evidence
began to accumulate that movements in
M2 velocity were becoming more pre-
dictable. The reemergence of the old
relationship is evident in figure 3. Prior
to the breakdown, velocity exhibited a
trend increase of less than 0.3 percent.
After shifting upward for a number of
quarters, the trend resumed a rate more
consistent with its historical relationship
to opportunity cost. This transition is
estimated to have begun in the second
quarter of 1990 and to have ended in the
fourth quarter of 1993.5
FIGURE 1 M2 AND M3 GROWTH
a. Growth rate for 1997 is calculated on a November over 1996:IVQ basis.
NOTE: Data are seasonally adjusted. Dotted lines are FOMC-determined provisional ranges.
SOURCE: Board of Governors of the Federal Reserve System. n n A Role for M2? 
Between the mid-1980s and early
1990s, M2 served largely as an interme-
diate target. Intermediate targets are use-
ful because the effects of policy actions
on ultimate policy objectives are uncer-
tain and often occur with a lag. Interme-
diate target variables serve as surrogates
for these ultimate objectives because
they are observable relatively quickly
and may be more directly controlled. If
the achievement of an intermediate tar-
get objective is to be consistent with
achieving an ultimate goal, then the
intermediate target variable must be reli-
ably related to the ultimate goal variable.
The experience of the early 1990s made
analysts question the reliability of the
long-run pattern of reasonably stable M2
velocity. Reestablishing confidence in
that relationship will undoubtedly
require a substantial period during which
a consistent pattern continues to hold.
Choosing not to target M2 growth is one
thing; choosing to ignore it is yet another.
In their deliberations, policymakers con-
sider an array of indicators of underlying
economic activity, none of which is im-
mune to unanticipated shifts. For exam-
ple, it is clear from the experience of
recent years that estimates of the nonac-
celerating inflation rate of unemploy-
ment (NAIRU) have not proved to be a
reliable guide for a price stability goal.
Nevertheless, many analysts continue to
consider the unemployment rate (ad-
justed for a downward shift, of course)
when assessing inflationary pressures.
Similarly, if evidence accumulates that
M2 velocity has indeed stabilized, pol-
icymakers will gain a useful and more
timely indicator of underlying economic
developments. Witness the experience
over the course of this year: At the out-
set, the FOMC expected the economy to
slow considerably (see table 1). Early in
the year, M2 growth accelerated sharply,
suggesting more strength than had been
anticipated given FOMC projections and
a relatively unchanged opportunity cost.
M2 growth remained near or above its
provisional range over most of the year,
despite a moderate increase in the fed-
eral funds rate. At its midyear report to
Congress, the FOMC substantially
raised its forecasts for both nominal and
real GDP. The preliminary estimate of
real output growth in the third quarter
reveals an increase of almost 4 percent,
consistent with higher-than-anticipated
money growth evident earlier in the year.
When using M2 growth to monitor
underlying economic activity, it is
important to account for changes in its
opportunity cost. For instance, when
interest rates drop because of declining
inflation expectations, the opportunity
cost of holding M2 initially falls, induc-
ing an increase in M2 demand relative to
a given level of economic activity. In
such situations, a temporary acceleration
in M2 is not likely to be associated with
an acceleration in economic activity or
increased inflationary pressures. Con-
versely, when an increase in the rate of
return on new business investment leads
to a rise in opportunity cost, M2 growth
might slow despite strengthening in the
underlying economy. 
SOURCES: U.S. Department of Commerce, Bureau of Economic Analysis; and Board of Governors of the
Federal Reserve System.
FIGURE 2 M2 VELOCITY AND OPPORTUNITY COST
SOURCES: U.S. Department of Commerce, Bureau of Economic Analysis; Board of Governors of the Federal
Reserve System; and author’s calculations.
FIGURE 3  M2 VELOCITY AND ESTIMATED TRENDSn n Trend M2 Growth
The M2 growth range can also provide
a benchmark for the trend growth rate
consistent with price stability. Figure 4
compares growth rates of M2, nominal
GDP, and the GDP implicit price defla-
tor over the most recent inflation cycle.
Each variable is based on a 10-year
average in order to focus on the long
term. Because the recent shift in M2
velocity implies that a given level of
money will be associated with a higher
level of nominal income, the estimated
velocity increase is added to M2 growth
over the period following the shift to
account for its effect on its relationship
with nominal income.6  The adjustment
hence provides an estimate of what M2
growth would have been in the absence
of the velocity shift. 
The long-term association between M2
and inflation is not just a characteristic
of the last inflation cycle. One recent
study showed that since the late 1880s,
every major acceleration in M2 has
been associated with a corresponding
rise in inflation, and every major decel-
eration in M2 has been connected with a
corresponding drop in inflation.7  The
author suggests that it would be wrong
for decisionmakers to conclude that
money doesn’t matter anymore based
on noisy short-term movements in M2.
He further argues that since the long run
consists of an accumulation of “short
runs,” sustained M2 growth should be
accorded some weight in formulating
monetary policy.
Critics of such a role for M2 believe that
although the aggregate may be behaving
more normally, episodes like that of the
early 1990s could recur. Indeed, many
would argue that advances in technology
are likely to spawn innovations that will
induce future upward—and unpredict-
able—shifts in M2 velocity. Clearly,
such possibilities force us to question an
excessive reliance on M2. 
On the other hand, one might argue that
the nature of these shifts should accentu-
ate a potential concern about persistent
accelerations in M2. If surprise shifts in
velocity are likely to be positive, then it
is all the more important for the FOMC
to contain M2 accelerations in order to
avoid trend growth above that of nomi-
nal GDP deemed consistent with price
stability. Moreover, some analysts have
argued that given recent advances in
technology, we might expect a perma-
nent increase in the velocity trend, per-
haps in excess of 1 percent. If so, trend
M2 growth of 5 percent would support
trend nominal income growth of 6 per-
cent or more—a pace that may be
inconsistent with maintaining our cur-
rent low inflation rates.
SOURCES: U.S. Department of Commerce, Bureau of Economic Analysis; Board of Governors of the Federal
Reserve System; and author’s calculations.
FIGURE 4 MONEY, NOMINAL OUTPUT, AND INFLATION
TABLE 1   ECONOMIC PROJECTIONS FOR 1997
(Percent)
FOMC
Central
Indicator Range Tendency Administration
February Humphrey–Hawkins Report
Change, fourth quarter to fourth quarter
Nominal GDP 4¼ to 5¼ 4½ to 4¾ 4.6
Real GDP 2 to 2½ 2 to 2¼ 2.0
CPI 2¾ to 3½ 2¾ to 3 2.6
Average level, fourth quarter
Civilian unemployment rate 5¼ to 5½ 5 to 5½ 5.4
July Humphrey–Hawkins Report
Change, fourth quarter to fourth quarter
Nominal GDP 5 to 6 5 to 5½ n.a.
Real GDP 3 to 3½ 3 to 3¼ n.a.
CPI 2 to 2¾ 2¼ to  2½ n.a.
Average level, fourth quarter
Civilian unemployment rate 4½ to 5¼  4¾ to 5 n.a.
SOURCE: 1997 Monetary Policy Objectives (footnote 1), February 26 and July 22, 1997.n n Concluding Remarks
The role of money in the formulation of
monetary policy has waxed and waned
over the years. The high-water mark was
reached in the late 1970s and early
1980s, when monetary targeting served
as a means to engineer a substantial dis-
inflation. Throughout the balance of the
1980s, monetary targeting continued to
provide a reliable framework within
which the FOMC could implement its
objective of achieving further progress
toward price stability. Despite the dimin-
ished role of money in the 1990s, the
FOMC has continued to advance that
cause. Up to this point in the decade,
however, the Committee has not faced a
sustained period of rapid M2 growth. 
Evidence on the stability of M2 velocity
is too limited to provide a reliable basis
for setting monetary targets anytime
soon. Nevertheless, it would seem
unwise to ignore M2 growth if it contin-
ues at its recent pace. Although one can
find sustained periods during which M2
growth exceeded trend levels consistent
with low inflation, these episodes fol-
lowed marked declines in inflation that
led to substantial reductions in inflation
expectations and hence sharply falling
interest rates. Lower interest rates ini-
tially reduce the opportunity cost of M2
and raise the level of M2 demanded rel-
ative to spending. The sharp accelera-
tion in M2 over the past year and a half
has not been associated with falling
interest rates. It would be unfortunate
and ironic if money serves a role for
policymakers only after inflation has
become a problem.
n n Footnotes
1. 1997 Monetary Policy Objectives: Fed-
eral Reserve Board Summary Report , Feb-
ruary 26, 1997, p. 18.
2.  In February and July of each year, the
FOMC sets annual growth ranges for the
monetary and credit aggregates. The Federal
Reserve Board Chairman presents these
ranges, along with projections for output,
inflation, and the unemployment rate, in tes-
timony before Congress pursuant to the
Humphrey–Hawkins Act of 1978.
3.  M2 was redefined in 1996. The new
measure excludes overnight repurchase
agreements and Eurodollars, for which data
are no longer available. The velocity of the
old measure was virtually trendless. 
4. For a more thorough discussion of these
events, see John B. Carlson and Benjamin D.
Keen,“M2 Growth in 1995: A Return to Nor-
malcy?” Federal Reserve Bank of Cleveland,
Economic Commentary, December 1995;
and Robert Darin and Robert L. Hetzel, “The
Shift-Adjusted M2 Indicator for Monetary
Policy,” Federal Reserve Bank of Richmond,
Economic Quarterly, vol. 80, no. 3 (Summer
1994), pp. 25–48. 
5. This interval is based on the pattern of 
the forecast error of a conventional M2 de-
mand specification. See John B. Carlson and
Benjamin D. Keen, ibid., p. 2. Other studies
also present evidence that a stable M2 rela-
tionship has reemerged. Yash Mehra broad-
ens opportunity cost to include yields on
bond funds after 1990. This has the same
effect as inducing a shift in mean velocity at
that time. Athanasios Orphanides and
Richard Porter use a regression-tree approach
to estimate real time shifts in equilibrium
velocity. They find evidence of a shift begin-
ning in 1990 and ending in early 1995. For
details, see Yash P. Mehra, “A Review of the
Recent Behavior of M2 Demand,” Federal
Reserve Bank of Richmond, Economic
Quarterly, vol. 83, no. 3 (Summer 1997), 
pp. 27–43; and Athanasios Orphanides and
Richard Porter, “P* Revisited: Money-based
Inflation Forecasts with a Changing Equilib-
rium Velocity*,” Board of Governors of the
Federal Reserve System, unpublished manu-
script, December 1996.
6. During the period of the shift, M2 velocity
is assumed to increase smoothly at an annual
rate of 3.77 percent. 
7. See William G. Dewald, “Money Still
Matters,” Barron’s, May 19, 1997. He com-
pares 10-year averages of M2, nominal GNP,
and the GNP implicit price deflator.
John B. Carlson is an economist at the Fed-
eral Reserve Bank of Cleveland. The author
thanks Kevin Sargent for research assistance.
The views stated herein are those of the
author and not necessarily those of the Fed-
eral Reserve Bank of Cleveland or of the
Board of Governors of the Federal Reserve
System.
Economic Commentary is available elec-
tronically through the Cleveland Fed’s site on
the World Wide Web: http://www.clev.frb.org.
We also offer a free online subscription serv-
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Accelerating money growth: is M2 telling us something?

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Accelerating money growth: is M2 telling us something?

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