Does Money Matter?

Relationship to GDP and Stocks

The velocity, or ratio of GDP to money supply, of the traditional monetary aggregates and MZM differs as well. In a July 1996 research letter, the Federal Reserve Bank of Cleveland attributed the different velocities to the outflow of small time deposits into mutual funds. It linked the outflow to the opportunity cost of keeping funds in T-bill instruments and measured a 4-percentage-point drop in demand for MZM for every percentage point increase in this opportunity cost.

The velocity of both M2 and MZM has been declining in the face of the Fed's aggressive rate-cutting campaign; the last datum is from the second quarter of 2003. This confirms the inefficacy of monetary policy in stimulating demand. Monetary policy may have prevented deflation, a real danger in the face of contracting credit demands.

Comparative Velocities

Source: Bloomberg.

It is axiomatic that excess liquidity finds its way first into financial assets; it is far easier to purchase a claim on a productive asset than to create the productive asset. Over the 1981-2000 period, the money supply as defined both by MZM and M3 had a very solid and near-linear percentage relationship with the growth of the S&P 500 index. Once the bubble broke, however, stocks fell even as the money supply continued to grow.

Unrelated Series

Source: Bloomberg

The question is raised whether stocks, which eroded in the face of an expanding money supply during the bear market, will now crumble in the face of slower or negative monetary growth. Only if total credit continues to contract in the face of both low interest rates and a resumption of global demand; total credit includes the global supply of liquidity available for conversion into dollars.

Given slack capacity and improving productivity, it is quite possible for loan demand to remain soft, both in the U.S and globally. Viewed in this light, central banks may need to remain vigilant against further monetary contraction until global growth is confirmed.

This means the Fed's decision to keep the funds rate at 1% for a "considerable period," while notably ineffective in achieving other goals, is laudable in forestalling what could be further monetary contraction, and thus it is to be commended.

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