Appetite of Investors for Bond Funds Complicates Fed's Measure of Money

WASHINGTON -- This year's rush by investors into bond mutual funds, including municipal funds, is raising some tough questions about the Federal Reserve's long-standing emphasis on money supply as a measure of economic health.

President Bush renewed his concern about slow credit growth at a meeting on Friday with the members of the cabinet-level Economic Policy Council and Federal Reserve Board Chairman Alan Greenspan. And last week, Michael Boskin, chairman of the President's Council of Economic Advisers, said the Fed "needs to do everything it can" to bolster growth in the money supply.

M2, the broad measure of money supply, has been growing at an annual rate of only about 2.5%, the bottom of the Fed's target range of 2.5% to 6.5%.

Senior Fed officials attending the annual meeting of the National Association of Business Economists, held last week in Los Angeles, said much of the slowdown in money supply growth is the result of the flight by investors from bank certificates of deposit into higher-yielding bond funds, which are not counted as part of M2. Money supply is still a concern, these officials said, but the answer is not necessarily lower interest rates.

Private economists attending the meeting offered some evidence to support the view that money supply may not be as big a problem as the administration suggests.

"What has gone on is a rapid reallocation of credit to nonfinancial institutions," said Jacob Dreyer, vice president and chief economist of the Investment Company Institute, the trade association for stock and bond funds. "You cannot ignore the fact that the role of banks has been taken over by others," he said.

There is plenty of financing available to borrowers at attractive prices in today's capital markets, Mr. Dreyer said, and the bottom line is that the amount of credit being supplied by the Fed "may be entirely sufficient to finance the recovery."

In the first half of the year, deposits at banks and thrifts contracted by $67 billion. During the same period, assets of bond and income funds jumped $52 billion, rising from $325 billion to nearly $377 billion. While some of the increase reflected portfolio gains, most of it came in fresh purchases with money taken out of the banks, said Mr. Dreyer.

According to a spokesman for the Investment Company Institute, total bond holdings shot up 12.% from the beginning of the year through the end of June. Assets of municipal bond funds, which account for over one-third of all bond holdings, jumped 11.5% to $133.3 billion.

Michael Darby, the Commerce Department's under secretary for economic affairs, took issue during a panel discussion with Mr. Dreyer and insisted money supply remains crucial to sustaining additional spending and an expanding economy.

"The reason we look at monetary aggregates and their growth is because they're the means of payment and influence the way people spend," Mr. Darby told reporters later.

The M2 measure of money, added Mr. Darby, remains an important tool "for measuring economic activity." Moreover, he noted, the Federal Reserve Board acknowledged slow growth in money as one of the reasons for its decision to cut the discount rate.

Senior Fed officials at the business economists' meeting played down the role of money supply as a factor in their deliberations on monetary policy. Robert McTeer, president of the Federal Reserve Bank of Dallas, warned that further cuts in short-term rates could simply make the money supply even more sluggish by sending more investors into bond funds for higher yields. "We could be chasing our own tail," he said.

But Mr. McTeer acknowledged that the credit crunch remains a serious problem. "We have too little credit," he said. "Banks appear to be retreating from risk."

Robert Parry, president of the Federal Reserve Bank of San Francisco, said he believes a moderate rebound in the economy can be achieved even if M2 grows below the midpoint of the Fed's target range. Mr. Parry said he expects to see real gross national product rise at a rate of 3% in the second half of the year.

Mr. Parry, who is a policymaker on the Federal Open Market Committee, conceded that Fed officials continue to attach importance to the money supply, but he called the relationship between money and the economy "highly volatile."

Much of the slowdown in M2 can be explained by the shift to bond funds and by the loss of deposits at savings and loan institutions as they are taken over by the government, said Mr. Parry.

Private analysts say they expect Fed officials will continue to rely on a variety of economic indicators in setting monetary policy, and those indicators are mixed. On that basis, there is reason to believe Fed monetary policy is again neutral with a bias toward easing rates, but only if the economic data remain soft.

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