By Ryan Barnes


Release Date: Weekly, every Thursday
Release Time: 4:30pm Eastern Standard Time
Coverage: M1 and M2 (M3 coverage discontinued as of March 2006)
Released By: Federal Reserve Board
Latest Release: http://www.federalreserve.gov/releases/h6/


Background
The money supply is just that: the amount of money floating around the economy and available for spending. Different numerical aggregates show different subsets of money based on their liquidity, starting with M0 (the most liquid), which is just the dollar value of physical cash and coin, and M1, which includes all of M0 as well as checking accounts, traveler's checks and demand deposits. The M2 aggregate includes the dollar value of all of M1 in addition to savings accounts, time deposits of less than $100,000 (such as certificates of deposit), and money market funds held by investors. (For related reading, see What Is Money?)

The Federal Reserve publishes data on the levels of M1 and M2 weekly, and has been collecting data on the money supply since the 1950s. In the less financially complicated world that existed then, the supply of money showed a very strong correlation to how much money was spent, and it was therefore studied fervently by economists for clues to economic growth.

Legislation passed in 1978 mandated the Federal Reserve to set annual targets for money supply growth. At the time, there was a still a high correlation between money supply growth and overall economic growth, as measured by gross domestic product (GDP). Over time, that close relationship started to break down due to changes in banking accounts, the proliferation of financing companies, and more widespread investment among consumers (stock and bond investments are not captured in M1 and M2 aggregates). When the legislation expired in 2000, the Fed announced that it would no longer set targets for growth of the money supply as a matter of policy, although it remains an important indicator for predicting inflation and spending patterns among consumers. In the words of the Fed, "…the FOMC [Federal Open Market Committee] believes that the behavior of money and credit will continue to have value for gauging economic and financial conditions."

The M2 aggregate is a large component of the Conference Board's U.S. Leading Index (which contains 10 indicators), making up more than 30% of the index.

What it Means for Investors
The Federal Reserve has a measure of control over the money supply aggregates, which differentiates this indicator from most others. Through open market operations such as buying and selling Treasuries and setting the reserve requirements, the Fed does things to alter the money supply through its daily course of business. Setting short-term interest rates to guide the economy remains the core policy directive of the FOMC, but changes to rates such as the fed funds rate do eventually manifest themselves in the money supply, albeit with a time lag. (To learn more, read Formulating Monetary Policy.)

No single release from the Fed regarding the money supply is going to shock the market; the weekly release schedule alone takes a lot of the surprise factor out mix, so this report will rarely move the markets in the short term. History has shown that the money supply tends to rise faster (accelerate faster) during periods of economic expansion that during contraction periods.

If there is one measure that is looked at more than the rest, it's the M2 figure - cash equivalents in this designation are deemed to be collectively liquid enough to be spent without any real delays or penalty costs. While growth in the money supply does not directly indicate future spending growth as it once did, it does indicate that inflation could be around the corner. This is where knowing both money supply growth and GDP growth becomes very handy - if money supply growth is rapidly outpacing economic growth, there will soon be more money chasing after the same amount of goods. This echoes the dryly famous quote: "Inflation is always and everywhere a monetary phenomenon."




Changes in the money supply are usually quoted in the media on an annualized percentage basis, which helps to smooth out short-term statistical "blips" that can occur week to week.


Strengths:
  • A timely and consistent indicator, released weekly and with a long operating history
  • It is often misunderstood by investors, creating opportunities for those who who know how to use it.
  • There is a lot of existing research on the relationship between money supply and GDP growth as well as inflation.
Weaknesses:
  • Rarely a mover of the markets in the short term
  • Limited breakdowns available in the weekly release; the quarterly Flow of Funds report provides a broader view
  • Lack of economic consensus on how to best compare money supply levels to inflationary outlook and future spending patterns
The Closing Line
The evaluation of money supply figures has become a progressive story, one that savvy investors will take into consideration when contemplating future levels of economic growth as well as inflation.


Next: Economic Indicators: Mutual Fund Flows »



comments powered by Disqus
Trading Center