Fisher Investments Editorial Staff

Debunking the Ms

By, 08/20/2008

Story Highlights:

  • The M3, a broad gauge of cash in the US economy, experienced a record one-month drop in July, adding to existing economic worries.
  • Given its broad scope, M3 is sometimes even viewed as a leading economic indicator.
  • But the "M" indicators don't carry the validity they once did. In fact, there are few reliable money supply indicators today.


If you took an economics course in college you may recall learning about M1, M2, and M3—indicators formerly used by the Federal Reserve to gauge money supply growth. Of the three gauges, M3 is the broadest measure of cash in the US economy. Despite the fact the Fed no longer considers this data useful for gauging US economic performance, some find reason to fret the indicator's sharpest monthly drop on record.

So, in addition to widespread fears of rampant inflation (implying a glut of cash), there's now concern a contracting money supply will bring down Wall Street too. That these polarizing worries are simultaneously getting press should at least raise an eyebrow, if not induce outright skepticism.

Here's a refresher in case you slept through class: The Ms indicate different classes of money. They range from M0, the narrowest gauge comprised only of cash actually circulating and held in the central bank, M1 which adds demand deposits (think checking accounts), M2 which adds savings, CDs, etc. to M3, which is basically the entire sum of cash in an economy from deposits to institutional money market funds and beyond.

M3 readings can be highly volatile. Just a couple months ago folks lamented the surge in M3, claiming it all but assured rampant inflation. Now just a month later the exact opposite is happening? Seems paradoxical. Over past decades, a number of developments have broken down the relationship between money supply growth and the performance of the US economy (if there truly was one in the first place). In July of 2000, the Federal Reserve announced it would no longer set target ranges for money supply growth.

Accurately measuring money supply isn't easy—in part because the methods used to create money have changed over time. Many believe the Fed simply turns on the printing presses to increase the supply of money. But that's not the case. Generally, if the Fed wants to increase the money supply, they lower interest rates, which in effect increases borrowing and pumps money into the system and can even increase the velocity of money in the system. When interest rates are low, borrowing tends to increase. As institutions lend more, money is created. So today's inflation hawks can't have it both ways: it would be near impossible to have aggregate lending activity fall of a cliff (which it hasn't) and simultaneously have rampant inflation.

As Milton Friedman taught us, inflation is always and everywhere a monetary phenomenon. True inflation involves too many dollars chasing too few goods. But without a good way to measure money supply it's exceedingly difficult to predict inflation in this way, and serves as yet another reason we believe market-driven indicators like long-term Treasury yields are a better way to gauge inflation looking ahead.

Here's something else to think about: Why believe US money supply alone will topple Wall Street? Truth is, looking at the US dollar in a vacuum doesn't tell the whole story. When it comes to today's globally integrated capital markets, seeing the global currency picture matters more.

Don't let the "M" factor, or rather, non-factor, spook you. Capital markets are evolving and creating actual money so fast that classifications of money can't keep up. Therefore, indicators like the Ms don't carry the power they once did. It's misguided to believe there's a simple catch-all indicator that accurately depicts money supply and therefore gives a clear indication of the future. The global economy changes constantly and necessitates ongoing innovation in analysis methods in order to gain valuable insight.

*The content contained in this article represents only the opinions and viewpoints of the Fisher Investments editorial staff.

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*The content contained in this article represents only the opinions and viewpoints of the Fisher Investments editorial staff.


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