Fine-Tuning Key Money Supplies
It is a truism - or at least a cliche - to say that the Federal Reserve should encourage enough money growth to stimulate the economic recovery, but not so much as to finance more inflation.
Truism or not, achieving such an outcome always represents a difficult balancing act.
And it should be even tougher in this economic recovery because the Fed intends to reduce the rate of inflation while also being stimulative.
Thus far, I would say the Fed has taken a middle course that has succeeded in keeping the recession fairly shallow and has permitted a turn toward recovery. But there is some doubt whether this course - typified by expansion in M2 money supply at about a 4% annual rate over the first six months of the year - would be sufficient to sustain recovery at a satisfactory pace.
Dramatic M2 Growth Needed
The arithmetic that relates money growth to economic activity is simple, but the economics is complicated. The arithmetic suggests that M2 growth would have to accelerate rather substantially if expansion of nominal GNP in the early stages of recovery were to be in the area of 6% to 8% (annual rate). If the velocity (or turnover) of M2 is to be unchanged - which would be roughly consistent with past norms - M2 would need to expand by a similar amount to accommodate the recovery.
I have little doubt that in practice M2 growth will have to accelerate from its recent pace if the economic recovery is to be adequately financed. But it may not have to expand quite as rapidly as the arithmetic suggests. It depends on how active a role banks (as well as other depository institutions) play in financing the recovery.
Banks are clearly in a conservative frame of mind with regard to lending and risk-taking. Moreover, the whole depository system is in the process of restructuring. That would not in itself reduce the pace of aggregate bank credit and deposit expansion, but slower credit growth may well be at least a temporary byproduct of devoting more bank management time to restructuring efforts.
Constraints on Expansion
If credit growth at banks and other depository institutions is not to play as strong a role as usual in financing the recovery. M2 growth will be constrained because these institutions will not make a particularly active effort to attract funds. While the velocity of M2-type money will increase under those conditions, the rise might not be accompanied by the significant upward pressure on interest rates that occurs when rising velocity means the market is competing for scarce money.
Interest rates could stay down because the part of the nation's saving unwanted or unneeded at banking institutions may willingly flow into market instruments through other well-developed channels.
Thus, as institutional structures change, interpretation of the behavior of monetary aggregates becomes a matter not of arithmetic but of assessing what lies behind shifts in the pattern of credit supply and asset holdings.
Technological and regulatory changes in the early 1980s changed the structure of finance and led to the demise of so-called M1 (money narrowly defined as currency and checking accounts at banks and thrifts) as a reliable policy aggregate. And M2 came to have more importance because by its very breadth it subsumed and neutralized the structural changes.
M1 Measure May Now Be Useful
In present circumstances, the behavior of M1 might be helpful in interpreting the adequacy of M2 growth. On the face of it, one might well have concluded that a 4% annual rate of growth of M2 in the first half of this year would not be sufficient to stimulate a recovery in the second half. However, M1 expanded at about an 8% annual rate over the same period, more than sufficient to lead to recovery.
Indeed, if M1 continued at such a rate into the second half of this year, it might have undesirable inflationary implications. In a recovery, it would be natural for the public to draw down some of the liquidity built up during the recession in the form of "unused" transactions balances. But if the Fed kept restoring those funds, they could later be absorbed by inflation.
A reasonable outcome over the balance of the year would be for M1 growth to decelerate and M2 growth to accelerate - a policy mix that might finance the recovery but also ensure that inflationary pressures remain subdued.
Mr. Axilrod is vice chairman of Nikko Securities Co., New York.