Fed Report Links Slowdown in Money Supply To Appetite Among Investors for Bond Funds

WASHINGTON - The rush by investors to get out of maturing certificates of deposit at banks in order to capture higher yields in bond funds and Treasury securities is a chief factor behind the big slowdown in the money supply growth, the Federal Reserve Board said yesterday.

The finding by the Fed. based on two surveys of 78 large commercial banks operating in the United States, marked the first public acknowledgment that the recent steepening of the yield curve was leading investors to reach for higher returns in bonds and other financial instruments outside the banking system.

Stock and bond mutual funds, as well as Treasury securities, are not counted in the money supply. Recently, the closely watched M2 measure of money has fallen below the annual target range of 2.5% to 6.5% set by Fed policymakers.

"One thing that many of the banks said was that the return on non-deposit instruments, such as bond funds and Treasury securities, explained the slow growth in deposits," said one Fed official who did not wish to be identified. "Bond funds tend to be paying higher rates than short-term liquid assets that you can find at banks."

According to Lipper Analytical Services Inc., the average 12-month yield on money market funds at the end of July was 6.5%, compared with 8.0% on U.S. government bond funds. Municipal bond funds were yielding about 6.5% in tax-exempt earnings, which made them worth more compared with taxable money funds.

Short-term interest rates have been sliding steadily since last fall as the Fed eased monetary policy in a softening economy. Intermediate and long-term rates have not come down as dramatically, although since July there has been a big rally in bonds that has brought the yield on the Treasury 30-year bond down to 8.0%.

The Fed's findings were based on a survey of senior financial officers at banks and a separate survey of senior loan officers. Both surveys are taken irregularly to get an assessment of credit conditions.

The survey of senior financial officers found many banks were experiencing weaker-than-usual growth in retail deposits. Besides the appeal of bond funds and other non-deposit instruments, according to the survey, banks cited local economic conditions and their own efforts to cut costs as reasons for the slowdown.

In many cases, banks made clear that they were not looking to attract funds. Half of the banks surveyed attributed the weakness in deposits to the rates they offered savers, their own fees, or cutbacks in advertising and other efforts to lure depositors.

Over the last year, Fed officials have cited slow growth in the money supply as a major source of concern, and many analysts believe the Fed is on the verge of slashing short-term rates again to try to boost a weak economy. A cut in the discount rate is widely expected to lead banks to slash the prime lending rate to 8.0% from 8.5%.

However, the Fed report said banks do not have plans to step up their loan activity as they struggle to build up capital and profits. "It would appear that banks do not anticipate a sizable acceleration of asset growth over the remainder of the year, since very few intend to pursue retail deposits more aggressively," the report said.

The survey of senior loan officers indicated the credit crunch still prevailed at many banks, despite the reduction in interest rates and appeals by the Bush administration for stepped-up lending. Fewer banks surveyed indicated that they had tightened credit in the last three months, the Fed said.

On the demand side, about one fourth of the banks surveyed said that business loans from large corporate customers had weakened in the last few months, and only a few banks reported stronger loan demand from big firms. Loan demand from small business customers was about the same as usual, with half the banks surveyed reporting an increase in demand while the other half reported decreased demand.

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