Why the M2 Growth Spurt?

Quantitative Easing (both I and II) has caused the monetary base—the sum of currency and bank reserves—to explode in the past three years, but has not resulted in similarly large increases in the growth of broader measures of the money supply such as M2. Instead banks have largely held the extra money that the Fed created in order to finance its purchases of longer term Treasuries and mortgage backed securities. You can see this in the following time-series chart. As the monetary base (right scale) increased sharply, the ratio of M2 to the monetary base—the M2 multiplier (left scale)—has moved in the opposite direction in complete lock-step fashion. Thus changes in the multiplier have offset increases in the monetary base.

But if you look closely at the lower right of the graph, you can see that this pattern may have shifted recently as the M2 multiplier increased. In fact, over the past couple of months, M2 growth has spurted, as you can see in the next chart showing monthly M2 averages through July.

It’s important to find out why. Is quantitative easing finally leading to a rapid increase in the supply of the broader money aggregates? If so, the Fed will need to be concerned about the ultimate effect on inflation, and perhaps start reducing the size of its balance sheet (and thus the monetary base) sooner than it would otherwise. Or is the increase due to a sudden rise in the demand for M2, which, with the elevated level of the monetary base, would not require additional adjustments. It’s probably too early to tell for sure, but the Fed’s weekly Money Stock Measures, released each Thursday afternoon, will be important to monitor in the weeks ahead.

The next chart shows the weekly data on M2 through August 8, which were released last Thursday afternoon. Based on a scan through the release, it looks to me like demand deposits and savings deposits at banks are the two components of M2 that are most responsible for the recent increase in M2. I have plotted the sum of those two items below M2 in the chart to demonstrate this (note the dual scale with M2 on the right and the sum on the left). Other components of M2 such as currency, small denomination time deposits, and other checkable deposits have not increased in this way.

What’s the reason for the sharp increase in demand deposits and savings deposits at banks? Perhaps the collapse of interest rates on Treasuries and the risk that Treasury prices could fall from these high levels have made such deposits more attractive, recalling the phrase of Keynes that the bond bulls “join the bear brigade.” The newly announced policy at Bank of New York Mellon that large depositors will have to pay to lodge their funds is consistent with this story. If so, we are seeing a shift in the demand for money. But stay tuned.

About John B. Taylor 117 Articles

Affiliation: Stanford University

John B. Taylor is the Mary and Robert Raymond Professor of Economics at Stanford University and the Bowen H. and Janice Arthur McCoy Senior Fellow at the Hoover Institution. He formerly served as the director of the Stanford Institute for Economic Policy Research, where he is now a senior fellow, and he was founding director of Stanford's Introductory Economics Center.

Taylor’s academic fields of expertise are macroeconomics, monetary economics, and international economics. He is known for his research on the foundations of modern monetary theory and policy, which has been applied by central banks and financial market analysts around the world. He has an active interest in public policy. Taylor is currently a member of the California Governor's Council of Economic Advisors, where he also previously served from 1996 to 1998. In the past, he served as senior economist on the President's Council of Economic Advisers from 1976 to 1977, as a member of the President's Council of Economic Advisers from 1989 to 1991. He was also a member of the Congressional Budget Office's Panel of Economic Advisers from 1995 to 2001.

For four years from 2001 to 2005, Taylor served as Under Secretary of Treasury for International Affairs where he was responsible for U.S. policies in international finance, which includes currency markets, trade in financial services, foreign investment, international debt and development, and oversight of the International Monetary Fund and the World Bank. He was also responsible for coordinating financial policy with the G-7 countries, was chair of the working party on international macroeconomics at the OECD, and was a member of the Board of the Overseas Private Investment Corporation. His book Global Financial Warriors: The Untold Story of International Finance in the Post-9/11 World chronicles his years as head of the international division at Treasury.

Taylor was awarded the Alexander Hamilton Award for his overall leadership in international finance at the U.S. Treasury. He was also awarded the Treasury Distinguished Service Award for designing and implementing the currency reforms in Iraq, and the Medal of the Republic of Uruguay for his work in resolving the 2002 financial crisis. In 2005, he was awarded the George P. Shultz Distinguished Public Service Award. Taylor has also won many teaching awards; he was awarded the Hoagland Prize for excellence in undergraduate teaching and the Rhodes Prize for his high teaching ratings in Stanford's introductory economics course. He also received a Guggenheim Fellowship for his research, and he is a fellow of the American Academy of Arts and Sciences and the Econometric Society; he formerly served as vice president of the American Economic Association.

Before joining the Stanford faculty in 1984, Taylor held positions as professor of economics at Princeton University and Columbia University. Taylor received a B.A. in economics summa cum laude from Princeton University in 1968 and a Ph.D. in economics from Stanford University in 1973.

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