Federal Reserve Money Supply

Why is it important?

According to the legislation passed in 1978, the Federal Reserve was mandated to set annual targets for money supply growth. At the time, there was a high link between money supply growth and the overall economic growth, as measured by the GDP. However, the relationship declined with the changes in banking accounts as well as the proliferation of financing companies, the Fed however announced that it would no longer set targets for growth of the money supply as a matter of policy upon the expiry of the legislation. In spite of that, it has remained an important indicator for predicting inflation and the spending patterns among consumers. The money supply is still a major driving force behind the direction of economic growth. Failing to set targets of money supplies has given the market a liberal chance at moving at its own pace. The federal board can only move in to check on any detrimental excesses that may negatively affect the economy. Evaluation of money supply status will always remain an important factor for any investor to take into consideration when contemplating future levels of economic growth.

How is it computed?

Money supply is the amount of money floating around and available for spending in the economy. Different numerical aggregates show different subsets of money depending on their liquidity, there are three subsets in the category thus the M0, M1, and M2. M0 is the most liquid and signifies the dollar value of physical cash and coin. M1, which includes all of M0 as well as checking accounts, traveler's checks and demand deposits, comes second. The M2 aggregate includes the dollar value of all of M1 in addition to savings accounts, time deposits of less than $100,000 such as certificates of deposit, and money market funds held by investors. The Federal Reserve publishes data on the levels of M1 and M2 on a weekly basis since the 1950s to date.

Prior to the year 2005, the Federal Reserve used to publish the above subsets plus the M3. M3 was however excluded from the equation basing on the augment that it did not convey any additional information about economic activity compared to M2. The board thus discovered it was using too many resources to collect information whose impact did not match the revenue spent to gather. It was therefore excluded from the statistics. The most notable role it played was only to display the rate at which the central bank was either making money out of the levies and was thus thought to be discouraging since common sense tells us that a government central bank creating new money out of thin air depreciates the value of each dollar in circulation.

Impact on forex

That relation between money and prices is historically associated with the quantity theory of money there is strong evidence of a direct relationship between long-term price and money-supply growth. This trend influenced the current reliance on money supply as a means of controlling inflation. Although money supply should be left to find its own balance depending on the market transactions, the money supply still influences the changes in forex trading rates.

Cash equivalents in the M2 figure are deemed collectively liquid enough to be spent without any real delays or penalty costs. While growth in the money supply does not directly indicate future spending growth as it once did, it does indicate that inflation could be around the corner. Knowing both money supply growth and GDP growth becomes very handy in such circumstances, if money supply growth is rapidly outpacing economic growth, there will soon be more money chasing after the same amount of goods. This will no doubt lead to inflation and subsequent changes in the forex rates as a result.

The federal money supply rate is lowered when the Federal Reserve is planning to decrease overall interest rates in order to give a stimulus to the economy to inspire growth, and it is raised when the economy is supposed to grow excessively and is threatened by the risk of inflation. The accompanying statement is always an important indicator of the monetary policy direction by the Federal Reserve and the immediate actions yielded by Treasury after its public presentation reflect this statement’s interpretation. However this report is a lagged indicator and does not trigger any significant increase or decrease in economic activity

How does it affect the stock market?

No single release from the Fed regarding the money supply is going to shock the market; the weekly release schedule takes away the anxiety from the report. The report therefore rarely moves the markets in the short term. History has shown that the money supply tends to rise faster during periods of economic expansion than during contraction periods. Basing on the historical findings it is therefore right to state that the money supply is a lagged indicator and can therefore not have a dramatic effect on the trends of the stock market.

The Federal Reserve System and public as well as private-sector analysts have for a long monitored the growth of the money supply because of the effects that its growth is believed to have on real economic activity as well as on the price level. Over time, the Fed has tried to achieve its macroeconomic goals of price stability, sustainable economic growth, and high employment by partially influencing the size of the money supply. In the recent past, however, the relationship between growth in the money supply and the performance of the U.S. economy has become much weaker, and emphasis on the money supply as a guide to monetary policy is rapidly wearing out as new monetary legislation take effect. The money supply has been less and less pivotal in determining investment directions as the market has come to rely more on more reflective indicators such as the employment reports among others.