checking customers. These accounts move checking account deposits with relatively low activity to money market deposit accounts. The advantage to the customer is a higher rate of interest. The advantage to the bank is that it is able to reduce the amount of reserves it is required to maintain. These reserve balances, of course, do not earn interest. This development has created a distortion in the supply of reserves and in narrowly defined money, or M1. The Fed estimates the cumulative amount swept from transaction accounts into money market deposit accounts through this September at $34.3 billion. The rate of movement accelerated sharply in May and has continued apace, facilitated by innovative software. In the five months through September, the transfer amounted to about $24.4 billion, lowering the rate of growth of M1 by an estimated 2.8 percentage points. The Fed executes monetary policy by targeting the federal funds rate. Since the demand for required reserves is declining while, other things equal, the supply is not, the Fed has to contract the supply if it is to prevent the federal funds rate from falling. The market would interpret a lower federal funds rate as an easing in monetary policy, something the Fed would not want to communicate, even if the lower rate were the result of a technical adjustment rather than a policy initiative. Thus, on balance, there has been a slowing in reserve infusion and M1. Indeed, a review of narrowly defined money and reserve aggregates suggest that the Fed is being restrictive. M1 and total checkable deposits have been declining sharply, and adjusted reserves moderately, over the past several months. In contrast, broadly defined money, categorized as M2 and M3, has been rising rapidly. The economic effects are unclear, since Fed officials and economists are uncertain as to the mechanism by which monetary policy affects the economy. However, further substantial contraction of the reserve base would probably constrain the Fed in its ability to manage reserves and the money supply. Close to 65% of required reserves are now satisfied by vault cash. The rest is held as reserves at the Fed. As more banks transfer growing amounts of checkable deposits into money market deposit accounts, the reserve base held at the Fed will contract further. It seems likely, therefore, that the Federal Reserve will have to take remedial steps, such as levying reserve requirements on accounts presently exempt from them. Of course, if the Fed were permitted to pay interest on required reserves, a good deal of the incentive that banks currently have for offering sweep accounts would be removed. But that would take an act of Congress and seems highly improbable. This is one more example of the dynamism of the banking system and the need for banks and monetary officials to constantly adjust to innovation and new technology. Mr. Sherman is director of research at M.A. Schapiro & Co.

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