Indications are that the rapid pace of money supply growth that many believe has helped to fuel this year�s rebound in both the economy and the equity market, has begun to slow and by some measures has actually started to contract.   

A slowing in the growth of liquidity is normally a cause for concern, but the slowing appears to be at least partly related to the recent change in risk attitudes.  Increased risk-taking is essential in any economic expansion, and it appears that the recent slowing in money supply growth reflects an increase in risk-taking rather than either a contraction in credit availability, or decreased optimism about the economic outlook.

Money Supply Turns Lower

The recent downturn in the money supply and its potential impact on the U.S. economy was captured in the Conference-Board�s latest report on the index of leading economic indicators (LEI).  For the first time in five months, the LEI posted a decline, falling 0.2% in September.  Importantly, the decline was led by a decline in the money supply, one of the ten indicators included in the LEI.  The LEI data was the latest reminder of the recent pattern in money supply growth.

More recent data on the money supply was released last Thursday by the Federal Reserve (the data is released every Thursday at 4:30 p.m. ET).  The data sparked worries in the stock market, which fell about 1% the day after the release.  In the release, the Federal Reserve reported that in the week ended October 6th, M3, which is one of the Fed�s broadest measures of the money supply, fell $39 billion to $8.88 trillion.  M3 is now down $106 billion from the peak of $8.988 trillion set in the week ended August 11^th and the growth rate it posted over the past three months was the slowest since the period September 2000 to November 2000.  M3 is actually lower than where it was three months ago, the first decline May 1993 through August 1993. 

While the slowing is in the growth of the money supply is not new, I have noticed that investors have recently begun to pay more attention to the money supply data than is normally the case.  Investors are expressing worries about a possible drying-up of the liquidity that has helped to spur gains in both the economy and the stock market.  It seems that those who worry about the slowing in M3 are failing to put the recent slowing in the context of its past strength.  For example, in November 2001, M3 posted its biggest year-over-year gain since 1973.  In 2002, M3 continued to grow strongly, growing faster than its 20-year annualized average increase of 6.7%, increasing about 8% on a year-over-year basis.  The growth continued into 2003, with a growth rate of close to 9% through August.  

Money Supply Drop Reflects Withdrawals From Low-Yielding Assets

A close look at the composition of money supply growth posted over the past few years indicates that the growth was significantly influenced by the growth in deposits such as savings accounts and money market funds, particularly institutional money market funds.  This is important because it now appears that the recent slowing in money supply growth is the result of withdrawals from money market funds, particularly institutional money funds (part of M3), which fell about $40 billion in the latest week alone.  The withdrawals appear to be due to a funneling of money toward riskier assets and into the real economy.  This makes sense given the paltry negative returns rates of return that money funds now offer, especially when taxes and inflation are considered.  Moreover, it makes sense given the recent acceleration in economic growth, which is creating new opportunities to generate higher rates of return. 

Also slowing the growth of the money supply is a decline in mortgage refinancing activity, as there are now fewer dollars being extracted from homes, reducing the amount of money deposited into money market funds and the like.  True, while this means that there are fewer dollars available for spending, this should be offset by income growth�interest are rising presumably because the economy is strengthening enough to boost incomes.  An increase in personal income growth from its current year-over-year growth of 3% to a more normal 5% gain would boost incomes by almost $200 billion, easily dwarfing the loss of money generated from cash-out mortgages.

Another factor behind the slowing in money supply growth are the recent sales of securities by U.S. banks.  As banks sell securities to non-banks, deposit accounts fall when the non-banks withdraw money to pay for the securities the banks sell to them.  The banks are presumably selling their securities to generate higher returns in more traditional businesses, taking advantage of the improved condition of the economy.

Eventual Withdrawals Was Key Premise for Bull Case

When the money supply was growing strongly, the bulls on both the economy and the stock market pointed to that growth as a basis for optimism.  The premise was that with so much money on the sidelines earning negative real rates of return, both the economy and the stock market stood to benefit from an eventual migration of that money into riskier assets such as stocks, corporate bonds, and the like, as well into investments in the real economy.  Now that this appears to be happening, its effect on the money supply should be considered good news. 

What would be worse would be continued flight into money market funds and the like.  Such behavior would indicate that investors and businesses remained leery of the economic and financial climate and would prefer to be risk-avoiders rather than risk-takers.  That is not the stuff that expansions are made of.

The recent decline in M3 should therefore be seen as a reflection of an improved assessment of the economic outlook and the outlook for corporate profits.

(Note: The slowing in M3 does not appear to be rooted to any change in the behavior of the Federal Reserve.  The Fed is operating under an interest-rate targeting regime, meaning that the Federal Reserve must supply as much money as is necessary to keep the federal-funds rate, the interest rate that the Fed controls, at its target rate, now at 1%.  In such a regime, if the demand for money increases as a result of increased economic activity, the Fed must supply additional money into the banking system in order to keep the fed-funds rate at the target rate.  To underscore this point, note that the monetary base, a key gauge of the amount of money that the Fed injects into the banking system, continues to grow at a fast pace.)