Saturday, January 17, 2009

The Return Of Checkable Deposits (And M1)

Until 1994, the quantity of demand deposits and other checkable deposits grew at roughly the same rate as other money supply components. And then, if you look at the historical statistics something happened. The quantity of checkable deposits fell back sharply during the mid 1990s and then stayed stagnant at roughly or somewhat above $600 billion, even as the quantity of currency in circulation and other forms of deposits kept rising.

The explanation for this new trend was that Alan Greenspan in 1994 permitted so-called sweep programs, which transferred perceived excess amounts in checkable deposits to money market accounts. The reason why banks wanted to do that was that checkable deposits have formal reserve requirements whereas money market accounts have no reserve requirements. And as I've explained before, banks have (or more correctly had as I note below) strong incentives to minimize reserves, as holding reserves means that they forego interest income and as the Fed's promise to always bail out banks with liquidity problems means that the old motive for holding reserves is gone.

This "deregulation" is perhaps the only "deregulation" which can be said to have played a small role in creating the tech stock and housing bubbles, as sweeps in effect meant that reserve requirements were lowered, something which especially in the context of central banks having removed the traditional motive for holding reserves distorted the markets and helped fuel credit expansion (as lower reserve levels made expanded balance sheets more profitable given a certain level of interest).

Anyway, because of the sweep programs, any increase in the amount of money that the public puts in checkable deposits will be quickly "neutralized" and transferred into money market accounts, which is why the quantity of checkable deposits were so stable from the mid-1990s until just recently. Because the narrow money supply measure M1 consists of currency plus checkable deposits (and traveler's cheques, but that amount is relatively trivial), this also meant that M1 became quite obviously irrelevant as the key component of checkable deposits had become a constant number that never changed regardless of monetary conditions. The entire increase in M1 from 1996 to 2008 consisted in the increase in currency in circulation.

But now something has happened again. If you look at the M1 graph, you can see that there has been a recent sharp increase in M1 which only to a minor extent can be accounted for by an increase in currency in circulation. Instead, as can be see in the graph below, checkable deposits have suddenly surged after having stayed basically constant for more than a decade. They have now for the first time exceeded the pre-sweep peaks.

The explanation for this is that the rules have again changed. Remember, the reason why banks have tried to minimize checkable deposits is that they have wanted to minimize required reserves. And the reason why they have tried to minimize required reserves is that they have had an opportunity cost in foregone interest. But now that the Fed has started to pay interest on reserves, that motive for minimizing reserves has been removed. And with no motive for minimizing reserves, this means that there is no motive for performing sweeps any more, which is why checkable deposits (and therefore also M1) have increased so dramatically recently.

This doesn't mean that I now think M1 is the proper money supply definition, but it won't be fully as irrelevant as it was from 1994 to late 2008.


Anonymous Anonymous said...

Hi Stefan,

But how will this explosive growth in M1 impact the economy and asset prices?

When all this money goes into the economy, will FED really be able to drain all this liquidity so it doesn't effect the consumer prices?

8:20 PM  
Blogger stefankarlsson said...

It won't matter much directly as M1 remains too narrow, but since it does reflect a real increase in monetary inflation, it will eventually cause price inflation to return. The Fed has the ability to withdraw the money before price inflation returns, but it seems unlikely that they will do it since they will likely fear that a premature withdrawal of liquidity will cause another slumo.

9:55 PM  

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