Recent developments in several industrial economies, particularly in the three largest ones, raise important issues about how to judge the stance of monetary policy. In the United States, recovery from the recent recession has been exceptionally sluggish, whereas inflation has fallen to its lowest level in two decades. In Japan, growth has slowed considerably during the past eighteen months. In Germany, by contrast, inflationary pressures surged in 1991–92 following unification, although more recently growth has stagnated. At the same time, the evolution of broad monetary aggregates—which the monetary authorities have preferred to target or monitor—suggests that monetary conditions have been tight in the United States and Japan but easy in Germany. But other indicators—including nominal and real short-term interest rates, the slope of yield curves, and narrow monetary aggregates—suggest that monetary policy has eased in the United States and in Japan, whereas it has tightened significantly in Germany.
This annex examines the experiences of these three countries and, more briefly, those of selected other industrial economies in order to assess the reliability of indicators of the stance of monetary policy. The analysis shows that contradictions among the various indicators, as is now the case, often occur over the course of the business cycle. Moreover, the growth of the broad monetary aggregates now appears to be giving misleading indications of the true stance of monetary policy and of its probable effect on future growth and inflation. Appropriately assessing the stance of monetary policy and the need for policy adjustments therefore requires examination of a range of indicators.
In the United States, the recovery from the recession that began in the third quarter of 1990 has been unusually sluggish by historical standards: growth in the first four quarters following the trough has been only about half that in the weakest previous postwar recovery (Chart 20). Although several factors have contributed to this disappointing performance, there has been concern that the slow growth of M2, which has fallen below the bottom of the Federal Reserve’s target band, indicates that monetary policy has not eased enough to sustain a robust recovery (Chart 21). This behavior apparently contrasts with earlier experience, when a fall in velocity, typically due to a surge in M2, has usually preceded a pickup in output growth by about four quarters.
1As identified by the National Bureau of Economic Research.
The recent behavior of M2 has been sufficiently unusual to suggest that this aggregate may no longer be very useful for assessing the stance of monetary policy.1 During the 1970s, a positively sloped yield curve was associated with rapid growth of M2 relative to M1. After financial deregulation in the 1980s, however, this relationship apparently broke down; since the mid-1980s, an inverted yield curve has been associated with rapid growth of M2 relative to M1. The recent pattern reflects the fact that low short-term interest rates and high long-term rates reduce the attractiveness of short-term assets in M2 relative to both demand deposits and longer-term assets, thereby reducing the growth of M2.
Other factors have also contributed to the recent slowdown in the growth of M2. On the demand side, households and businesses may have been liquidating short-term assets in order to reduce their debt burden by paying down loans. On the supply side, depository institutions have been increasing the spread between the return on assets (loans) and the cost of liabilities (deposits, including time deposits) in response to low profitability, regulatory pressure to boost capital-asset ratios, slack loan demand during the recession and subsequent period of slow growth, and the perception that some loans are now riskier than before. As banks have consolidated the asset side of their balance sheets, they have had less need to raise funds and therefore have offered relatively low returns on instruments such as time deposits. Finally, asset shifts associated with closures of insolvent savings and loan institutions have reportedly slowed the growth of monetary aggregates.
Indicators other than M2 suggest that the stance of monetary policy in the United States has eased substantially. In particular, the narrow aggregate M1 has been growing robustly, and the dollar has weakened as short-term nominal interest rates have fallen to their lowest levels in three decades. Short-term real interest rates are now close to zero, the lowest level since real interest rates were negative in the early 1980s. Long-term interest rates, however, have fallen only modestly, resulting in a very steep yield curve. In contrast to the often confusing signals provided by monetary aggregates, the yield curve has proved to be a reliable indicator of economic activity, with a lag of about four quarters.2 In the 1974–75 recession, the yield curve became steeply inverted about four quarters before output growth turned negative; it then became positive as output recovered. A similar pattern occurred in the 1981–82 recession. The recent steepness of the yield curve has been signaling an upturn in economic activity for some time and is consistent with a recovery in output growth in 1993, although the process of resolving private sector balance sheet difficulties may continue to restrain the pace of expansion.
In Japan, as in the United States, the monetary aggregate monitored by the central bank (M2 + CD) has barely grown over the past eighteen months, suggesting very tight monetary conditions (Chart 22).3 This slow growth was preceded by unusually rapid growth in 1990, however, and to that extent may reflect a return of the aggregate to its underlying trend. The evolution of the monetary aggregates was also influenced by the sharp rise in market interest rates in 1990 and their subsequent decline through 1991. As interest rates rose in 1990, funds were shifted out of postal deposits, which are not included in M2 + CD, because returns did not rise as quickly as interest rates paid on other assets. Prime lending rates also rose more slowly than market rates in late 1990 and early 1991; in response, firms borrowed at prime and reinvested in CDs. As interest rates fell during 1991, funds were shifted back into postal deposits, and firms unwound their positions in CDs, with the result that growth of M2 + CD was unusually slow.
1 CD, certificate of deposit.
Indicators other than M2 + CD suggest that the stance of monetary policy has loosened somewhat. The growth of the narrow aggregate M1 increased during 1990–91 and, although it declined somewhat in 1992, it was at about the same level as average growth in the 1980s. In addition, short-term rates have fallen by over 300 basis points in the past eighteen months in Japan, and real short-term interest rates are at their lowest level in more than a decade (except for a brief period in 1989). Short-term rates have also fallen about a percentage point below long-term rates. As in other countries, a positively sloped yield curve is associated with high growth of the narrow aggregate compared with the broad one.
However, the factors underlying the recent behavior of monetary aggregates and other indicators in Japan are not completely understood, and it is therefore unusually difficult to judge whether current monetary conditions can sustain adequate growth in 1993. In particular, as in several other industrial countries, the collapse of equity and real estate prices has eroded the capital base of the banking sector, has resulted in a rise in nonperforming loans, and may also be depressing household consumption. The prospect that these effects may prove as pervasive and long-lasting as in other industrial countries suggests that the current stance of monetary policy in Japan is not overly expansionary.
In Germany, the twelve-month growth rates of the broad monetary aggregate M3 during the first nine months of 1992 were running well above the target range of 3.5 to 5.5 percent established by the Bundesbank (Chart 23).4 The rapid growth of M3 has been cited as an indication that monetary policy has been too loose. By contrast, following an upward surge during 1991 because of German monetary unification, M1 grew relatively moderately, despite a probable increase in the use of the deutsche mark in Eastern Europe and the former Soviet Union. Although moderate M1 growth suggests tight monetary policy, the divergence between the growth rates of the aggregates has complicated the assessment of the stance of policy. Historically, M3 has tended to grow more rapidly than M1 in response to a flattening or inversion of the yield curve—as has occurred during the past two years—because relatively high short-term rates increase the attractiveness of the short-term interest-bearing assets in M3. In addition, the prospect of the introduction of a withholding tax on interest income in mid-1992 may have induced movement out of longer-term assets and into the relatively liquid interest-bearing assets contained in M3.
Monetary unification has made movements in both the narrow and broad monetary aggregates misleading as indicators of monetary stance.5 In addition to a substantial once-and-for-all increase in money stocks of perhaps 15 percent, unification increased the demand for money from the eastern Länder. It will be difficult to evaluate how the behavior of asset holders and borrowers in east Germany will evolve; hence, the growth rates of the monetary aggregates may prove to be misleading guides to underlying economic conditions.
Whereas M3 and M1 have been providing mixed signals, other indicators suggest that monetary policy in Germany is now quite tight. Short-term nominal and, more important, real interest rates are very high by postwar standards. This has put considerable upward pressure on the deutsche mark and contributed to the recent turmoil in the ERM. Short-term interest rates are also now well above long-term rates, resulting in a yield curve that is as steeply inverted as at any time in recent history. As in the United States, an inverted yield curve has been a reliable indicator that monetary policy is exerting significant downward pressure on output growth.
Two previous episodes of inflationary pressure followed by monetary tightening are helpful in assessing the indicators of monetary stance. Germany experienced a surge of inflationary pressure in the early 1970s, as did other countries. In response, the Bundesbank raised nominal and real short-term interest rates, and the yield curve became steeply inverted. The downturn of economic activity in Germany during 1974–75 and the subsequent reduction of inflation testify to the success of the tight stance of monetary policy. Nonetheless, M3 continued to grow rapidly from early 1973 through late 1974, even as M1 growth collapsed. In 1979, the second oil shock triggered another inflationary upsurge, which was again accompanied by a tightening of monetary conditions. As in 1973–74, the growth of M1 fell sharply, even turning negative in 1981, whereas the growth rate of M3 remained relatively stable. The yield curve became inverted as short rates rose sharply, and, as in the previous episode, this was followed by a fall in output, although the disinflationary impact may have been blunted by the fall in the value of the deutsche mark relative to the dollar, which reflected in part very tight monetary policy in the United States. In light of both of these episodes, the current monetary indicators suggest a slowing of the German economy and receding inflationary pressures.
Recent difficulties in interpreting the behavior of monetary aggregates have not been limited to the three largest economies. In the United Kingdom, rising inflation became a key policy concern by late 1988, particularly in view of the prospect of entry into the ERM (which occurred in 1990). Monetary policy, which has used MO as the only targeted aggregate since 1987, was tightened considerably beginning in 1988 and over the course of 1989, remained tight through most of 1990, and then eased modestly beginning in late 1990. Short-term rates were pushed well above long-term rates from mid-1988 through late 1990 and then eased gradually to only about a percentage point above long-term rates during 1991, although they remained very high in real terms. In response, economic growth slackened somewhat during 1989, and a prolonged recession began in the third quarter of 1990. Meanwhile, inflation (measured by the “headline” twelve-month change in the retail price index) has fallen below 4 percent.
The growth of the broad monetary aggregate M4 remained high relative to that of the narrow aggregate throughout 1989 and into 1990. As economic activity began to weaken, the growth of M4 fell to levels not seen since the 1960s, suggesting an economy declining into a deepening recession. In contrast, the growth of the narrower aggregate began to fall in mid-1988, providing a more reliable indication of the earlier tightening of monetary stance in 1988 and 1989. The recent behavior of narrow money suggests an economy that is only barely growing. The situation in the United Kingdom in 1989 and early 1990 was thus similar to the current situation in Germany: a tight monetary stance accompanied by rapid growth of broad monetary aggregates. Monetary conditions were eased following the pound sterling’s entry into the ERM in late 1990, with short-term interest rates falling from 15 percent to 9½ percent in September 1992. Since sterling left the ERM, short-term rates fell further to 7¼ percent in early December—about 1 percentage point below long-term rates—and the pound has depreciated in effective terms by about 16 percent. These changes amount to a substantial easing of monetary conditions and should stimulate economic activity in 1993.
In Canada, where no monetary aggregate is targeted, inflation became the key policy concern during 1988–90, and monetary policy tightened considerably. Short-term interest rates were pushed up from mid-1988 until mid-1990 and stood more than 2½ percentage points above long-term rates from early 1989 until late 1990. As the economy slowed and inflation eased, short-term rates fell more than 700 basis points and were about 3 percentage points below long-term rates in August 1992. From already low levels in 1988, growth of the narrow monetary aggregate M1 declined further during 1989 and turned negative during 1990. In contrast, growth of the broad monetary aggregate picked up over the course of 1988–89, reached a peak for the decade at the end of 1989, and remained high through 1990. Since early 1991, growth of the broad aggregate has declined somewhat, whereas the growth of the narrow aggregate has picked up. The evolution of real output growth, which began to slow in late 1989 and turned negative in mid-1990, confirms the assessment of monetary policy indicated by the behavior of interest rates and the narrow aggregate. The behavior of the broad aggregate, in contrast, has been less useful as a guide to the impact of policy.
In Australia, determined efforts to combat inflation were clearly under way during 1989 as interest rates on short-term treasury bills were pushed to nearly 18 percent, 4 percentage points above long-term rates. The twelve-month growth of the narrow monetary aggregate M1 declined sharply from 36 percent at the beginning of 1989 to slightly below zero in early 1990. In contrast, the twelve-month growth of the broad monetary aggregate M3 rose to a peak of over 30 percent in mid-1989, ran above 20 percent by year-end, and was above 10 percent throughout 1990. Growth began to slow late in 1989; by mid-1990 a recession had begun, and inflation was falling. Again, the narrow aggregate appears to have reflected the stance of monetary policy more accurately than has the broad aggregate. The recovery that began in late 1991 is consistent with the sharp pickup in growth of the narrow aggregate, the persistent declines in short-term interest rates, and the increasingly positive slope of the yield curve since early 1991. At the same time, the broad aggregate has grown only slowly.
September 1990 Staff Studies for the World Economic Outlook, by the Research Department of the International Monetary Fund.
October 1990 World Economic Outlook: A Survey by the Staff of the International Monetary Fund.
November 1990 Multilateral Official Debt Rescheduling: Recent Experience, by Michael G. Kuhn with Jorge P. Guzman.
May 1991 International Capital Markets: Developments and Prospects, by a Staff Team from the Exchange and Trade Relations and Research Departments.
May 1991 World Economic Outlook: A Survey by the Staff of the International Monetary Fund.
October 1991 World Economic Outlook: A Survey by the Staff of the International Monetary Fund.
December 1991 Private Market Financing for Developing Countries, by a Staff Team from the Exchange and Trade Relations Department.
May 1992 World Economic Outlook: A Survey by the Staff of the International Monetary Fund.
May 1992 Developments in International Exchange and Payments Systems, by a Staff Team from the Exchange and Trade Relations Department.
August 1992 Issues and Developments in International Trade Policy, by a Staff Team led by Margaret Kelly and Anne Kenny McGuirk.
September 1992 International Capital Markets: Developments, Prospects, and Policy Issues, by Morris Goldstein, David Folkerts-Landau, Mohamed El-Erian, Steven Fries, and Liliana Rojas-Suarez.
October 1992 World Economic Outlook: A Survey by the Staff of the International Monetary Fund.
December 1992 Private Market Financing for Developing Countries, by a Staff Team from the Policy Development and Review Department led by Charles Collyns.
January 1993 World Economic Outlook—Interim Assessment: A Survey by the Staff of the International Monetary Fund.
This annex was prepared by Robert P. Ford.
M1 comprises demand deposits at commercial banks and currency. M2 comprises M1, savings deposits, overnight repurchases and Eurodollars, small time deposits, and money market mutual shares. The recent slowdown in M2 growth has been concentrated in small time deposits, which are interest-bearing, nonliquid instruments issued in denominations of less than $100,000. See the analysis in John Wenninger and John Partlan, “Small Time Deposits and the Recent Weakness of M2,” Federal Reserve Bank of New York Quarterly Review, Vol. 17 (Spring 1992), pp. 21–35.
For econometric evidence, see Arturo Estrella and Gikas A. Hardouvelis, “The Term Structure as a Predictor of Real Economic Activity,” Journal of Finance, Vol. 46 (June 1991), pp. 555–76. They find that the term structure is a better predictor of real output than the short-term real interest rate and the index of leading indicators.
M1 comprises currency and demand deposits. M2 + CD comprises M1, all other deposits with financial institutions, and certificates of deposit (CDs).
M1 comprises “sight” deposits and currency. M3 comprises M1, time deposits, funds borrowed for a period of less than four years, and savings deposits. The Bundesbank’s target range is based on an estimate of potential output growth and on the medium-term target of price stability.
One sign of potential instability in money demand is the clear break in the relationship between monetary aggregates and nominal income. The steady decline in M3 velocity has been reversed since sometime in 1989, even after adjusting money stocks for the once-and-for-all change associated with unification.
On the first point, see Jeroen J.M. Kremers and Timothy D. Lane, “Economic and Monetary Integration and the Aggregate Demand for Money in the EMS,” Staff Papers (IMF), Vol. 27 (December 1990), pp. 777–805, and the references contained therein. On the second point, see Tamim A. Bayoumi and Peter B. Kenen, “Using an EC-Wide Monetary Aggregate in Stage Two of EMU, “IMF Working Paper 92/56 (July 1992). The issue of an EC monetary aggregate is far from settled, however, as is indicated by the comment on Kremers and Lane by David Barr, “The Demand for Money in Europe,” Staff Papers (IMF), Vol. 39 (September 1992), pp. 718–29.