Bank Deposits, Cold Hard Cash Gain Currency

Last week, the Conference Board reported that its Index of Leading Indicators rose 0.3 percent in September, the first increase in the last five months. Six of the 10 components made positive contributions to the September increase. However, it's a little hard to get optimistic about the increase, coming on the heels of revised declines of 0.7 percent in July and 0.9% in August, respectively. October data available thus far for some of the series that make up the indicator have been quite weak.

The 10 components that make up the Conference Board's index of leading indicators are:

• Manufacturers' new orders for consumer goods and materials
• Manufacturers' new orders for nondefense capital goods
• Consumer expectations (from a consumer confidence survey)
• Spread on long-term interest rates over short-term interest rates
• Supplier delivery performance (from the ISM survey)
• Building permits
• Stock prices (using the S&P 500)
• Initial claims for unemployment insurance
• Average work week in manufacturing
• Real money supply

The largest positive contribution in September among the 10 components came from the Conference Board's estimate of the real money supply. To get the "real" money supply, the Conference Board deflates the Federal Reserve's M2 monetary aggregate by a price index.

It's been awhile since the monetary aggregates got a great deal of attention, the recent debate over the Federal Reserve's decision to stop publishing the M3 aggregate notwithstanding. But the money supply numbers are doing some extraordinary things lately, and the message from their behavior seems mixed at best.

The growth in M2 in recent weeks has been at some of the highest levels since 1983. The M2 number includes M1, and adds savings deposits, small denomination time deposits, and retail money funds. The growth in M2 in recent weeks reflected especially rapid increases in M1, the narrowest of the M's. M1 principally includes currency circulating outside of banks and demand deposits. Here's a look at a four-week moving average for M1 since 2000. The latest spike in M1 is in line with the extraordinary increase in the four weeks ended in late September 2001.

In turn, within M1, the increase in recent weeks has been reflected in both demand deposits and currency circulating outside of banks. The rapid increase in demand deposit balances reflects the efforts of the Federal Reserve to liquefy things in recent weeks. Here's a longer-term view of the behavior of demand deposits in commercial banks since 1975.

In their monumental work A Monetary History of the United States, Milton Friedman and Anna Schwartz documented how, amid a rapid increase in currency circulating outside of banks in the early 1930s, the overall M1 monetary aggregate fell sharply as people were liquidating their bank accounts without sufficient offsetting policy at the central banks to keep the overall aggregate rising. The currency/deposit ratio rose sharply. The Federal Reserve is clearly not letting that happen this time around, even as currency circulating outside of banks is rising sharply recently. However, as Schwartz argued in an interesting interview in the October 18-19 Wall Street Journal weekend edition, the Fed--and the Treasury and the Congress--may not be addressing the basic problem.

The M1 component comprised by the currency circulating outside of banks--the bills in our wallets (and, apparently and increasingly, in our mattresses)--could be considered the narrowest definition of "money." In recent weeks, the growth rate in currency circulating outside of banks has been in line with the extraordinary increases in the four other intervals that provided the fastest growth in this measure since World War II--the pre-Y2K period, January 1991, July-August 2001, and July 2004. The financial market difficulties we've had in recent weeks haven't only been in the United States. Demand for U.S. currency from Argentina may be running at especially rapid rates recently.