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November 15, 2005
Much Ado About M3
A minor buzz has developed over last week's announcement from the Federal Reserve Board that it will discontinue the publication of the M3 monetary aggregate, effective March 23 2006. You can find, not exactly positive, commentary from Mark Thoma (here), from Barry Ritholtz, from the Prudent Investor (here and here).
Let me be very clear -- I speak only for myself here. The data collection function is a role that is delegated to the Board of Governors, and only they are in a position to comment on the whys and hows of the decision to discontinue collecting the data that makes up the M3 aggregate. But, for my part, I think a good starting point is the opinion expressed at Institutional Economics:
Growth rates in broad money and credit aggregates tend to be dominated by trends in financial intermediation and thus have only a very tenuous relationship with monetary policy and even a somewhat loose relationship with economic activity.
From the point of view of a policy maker, why do we care about monetary measures in the first place? We care for the same reason everyone else does -- because most of us still believe that, ultimately inflation, inflation is everywhere and always a monetary phenomenon. Here is one famous picture of this relationship, from George McCandless and Warren Weber:
That picture is based on the monetary aggregate M2. McCandless and Weber explain this, and the other measures of money, they use in their study:
For each country with 10 or more years of data (110 countries), we calculate the geometric rate of growth for consumer prices... three definitions of money—M0, currency plus bank reserves...; M1, money easily used in transactions...; and M2, money easily used in or converted into use for transactions...
In short, monetary theories tell us that monetary assets are those that are held, at least in large part, for the purpose of supporting transactions. M0, M1, and M2 arguably fit that definition. Here is the definition of M3, from the Federal Reserve's education site (hat tip, Mark Thoma):
M3 — Measure of the U.S. money stock that consists of M2, time deposits of $100,000 or more at all depository institutions, term repurchase agreements in amounts of $100,000 or more, certain term Eurodollars and balances in money market mutual funds restricted to institutional investors
Some of the items in M3, but not in M2, are more likely than others to fit the definition of transactions balances. Institutional money market mutual funds, for example. That series is in fact part of another popular monetary measure, MZM. But that series is not being discontinued, presumably because it is used in constructing a monetary measure that is useful for thinking about the transactions balances of the public.
And there is this to think about. The McCandless and Weber study is about the correlation between money growth and inflation, which is the connection that all of monetary theory leads us to. The Big Picture repeats a picture, originally appearing at Economist's View, that highlights the levels of M1. M2. M3. Here is my version...
... and sure enough there is an acceleration of M3 relative to both M2 and M1 that starts in the early 1980s (and accelerates with the asset-price booms the begin in the mid-1990s). These trend differences are, with as close to certainty as we get, a result of financial market innovation and change that have very little to do with monetary policy. And, in this case, a look at the accumulated effects of these trend differentials can be quite deceiving. Here is a look at the more relevant (for inflation) growth rates of these monetary measures:
The growth rate of M3 is indeed generally higher than the growth rate of M2 (as must be the case given the levels picture), but not dramatically so. And there is absolutely no evidence that the difference between the two has been growing of late -- just the opposite, in fact.
For my money, the much ado about the pending disappearance of M3 is much ado about not much.
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