What Tight Money Means

There's a lot of discussion right now about the impact of the recent "tightening" by the Federal Reserve in the United States which moved up the benchmark Fed Funds rate from 5.25% to 5.5% . The Chairman of the Federal Reserve, Alan Greenspan, is in the news on an almost daily basis with his diagnosis of the health of the U.S. economy and sometimes with some prescriptions for his massive and lumbering patient. Given the byzantine, convoluted and often contradictory nature of his public utterances, it's no small wonder that the average investor hasn't got a clue what he's up to.

To top it off, the so-called experts of Bay and Wall streets are pretty confused themselves and the financial media is rife with conflicting views of what "tightening" of monetary policy will mean to the U.S. economy and financial markets. After a healthy economy and rising financial markets for as long as most investment neophytes can remember, it is currently fashionable among economic commentators to question if "money matters any more?" There's lots of great reasons to disparage the impact of monetary policy, demographics and "downsizing" being popular, but savvy investors know better. Monetary policy is one of the most potent forces in the financial markets. Abuse this concept at your own risk!

Monetary policy is the name for the methods that national governments use to manage a country's supply of money and credit. By manipulating the availability of money and credit, national governments attempt to influence the overall level of economic activity. In most modern countries, by law, only the national government can produce currency. This allows governments to vary the amount of currency and credit, since the creation of money through the banking system is one of the key determinants of the availability of loans. All countries also closely regulate their financial institutions and use their control of a country's financial system to try to influence their economies.

Experts are divided on exactly what the impacts of monetary policy are for a modern economy. They also and debate the "transmission mechanism" or the manner by which monetary policy works. This debate divides economists and financial analysts into "economic schools" or camps which affects their way of looking at these issues. This debate might seem a bit dry and irrelevant to the layperson but it has important ramifications for how an investor views the effect of monetary policy on the financial markets.

Money matters at the extremes

The actual conduct of monetary policy is not that far removed from our simple game of Monopoly. There is almost universal agreement on the effects of monetary policy at the extremes. More money means higher inflation and interest rates and less money means lower inflation and interest rates. Take the runaway printing presses of the Weimar Republic, or Germany in between the First and Second World War.

Given the political and economic turmoil in Germany in the 1920s and early 1930s, an almost limitless supply of money was printed. Severe inflation or "hyperinflation" resulted as the mark rapidly lost its value. All goods and services increased in value compared to worthless paper currency. Germans had to take wheelbarrow loads of marks into their stores to buy loaves of bread. Interest rates soared as investors tried to protect the rapidly declining value of their marks. People on fixed incomes were impoverished as their incomes were stagnant in the face of rapidly increasing prices. This experience with hyperinflation is the reason why the Bundesbank, the German central bank, keeps such a tight rein on German money supply and inflation to this day.

This story of rapidly growing money supply and hyperinflation has been repeated many times and is currently the case in the former communist countries of Eastern Europe like Russia and Poland as well as Brazil. On a happier note, those countries with high levels of inflation that severely restricted monetary growth have had their inflation rates drop substantially. This has been the case in Chile and Argentina, formerly high inflation countries with much lower rates of inflation with moderate money supply.

What is not so clear is the conduct of monetary policy in non-extreme situations. In a modern industrial society, it is not obvious what appropriate monetary policy necessarily is or even what constitutes money and credit. Money and credit are the very things that monetary policy seeks to control, yet defining these or even determining their levels is a very difficult task.

What is money supply??????????????

Compared to the simple and obvious money in our monopoly game, there is considerable argument and confusion over what currently constitutes "money supply" and what the growth rate of the various aggregates really means. Economists define money supply according to a liquidity standard, how easily available the forms of money are. The traditional "narrow" form of money is called M1 and includes currency, bank deposits, and short term savings accounts. As modern economies developed new forms of deposits and financial instruments these were added to a "broader" money supply "aggregates" called M2 and M3, which include things like money market mutual funds and "sweep" accounts. Some economists are even adding in stock and bond mutual funds, which they argue can be spent or used practically on demand, for a measure they call "MZM".

Monetary aggregates can grow at very different rates and can be taken to mean very different things. Those with an economic axe to grind can find very different statistics supporting their viewpoints by selecting their favourite monetary aggregate as "money supply". In the United States presently (April 1997), M1 is actually shrinking dramatically, which in years gone by would have been the precursor to a severe recession. This is due in large part to the development of money market "sweep" accounts by the banking industry. Rather than letting money stay in low interest accounts over night, banks are electronically "sweeping" these funds into special "sweep accounts" that pay interest based on Treasury Bill interest rates. When the funds are taken out of the normal accounts, they no longer appear in M1. When the "sweep account" monies are added back to M1, it shows a reasonable level of growth. At the same time that unadjusted M1 has been dropping dramatically, M2 is showing strong growth. Since M2 includes longer term deposits, which fund lending activity, this could be a sign of monetary strength which is reflected in high credit growth statistics. Those forecasting and hoping for a recession, which would bring lower inflation and interest rates, point to the weakness in M1. Those arguing that the economy is strong and will inevitably lead to higher inflation and interest rates point to the stronger growth in M2. The argument won't be "over until it's over", but it's this argument over the various measures and their interpretation that leads to investors to throw in the towel and claim that "money doesn't matter any more".

Now that Mr. Greenspan has thrown his vote towards the "strong growth/inflation" camp with his 1/4% increase in the Fed Funds rate, we know that money growth will be purposefully reduced by the Fed to slow the economy down. Tired of arguing about monetary aggregates, our experts can debate the timing, implementation and effects of monetary policy. These arguments basically break down into two camps concerning the "transmission mechanism" of monetary policy:

• those who believe that it is the level of interest rates that directly affects economic activity. As rates rise, people making economic decisions reduce investment and spending as credit becomes more expensive. It is the actual interest rate increases that matter, not the change in money supply which is just the manner to change interest rates. This is a "Keynesian" argument, although most making it don't realize the genesis of their ideas; and
• those who believe that it is actually physical supply of money that changes the availability of credit and money and makes it harder to conduct economic activity. The actual quantity of money is their important variable leading to the term "quantity theory of money". This is the "Monetarist" argument.

Both Keynesians and Monetarists believe in the effectiveness of monetary policy. Where they differ is in how it effects the economy. The Keynesians believe in a smoother world, where interest rates act as a thermostat of sorts. The central bank sets the interest rate thermostat to a certain level by manipulating money supply and the economy adjusts its temperature accordingly. The Monetarists live in a more discontinuous world, where the change in money supply actually directly affects economic activity by making it harder to find the money to make loans or spend.

What's all this mean for my precious portfolio, you might ask. It's simple if you're a believer and this bond manager falls squarely into the monetarist camp. Think of the monopoly game. More money means happier players. Less money means unhappy players. If the economy is the total value of all goods and services produced or alternatively all income paid, less money available will obviously mean a reduced economic activity.

The withdrawal of the monetary tide also means less money and credit, lower cashflows and lower asset values. There's not enough money at the best of times to pay for the supposed value of all assets, both financial and real. Any of the monetary aggregates is dwarfed by the sheer magnitude of the total value of investments or the economy. Asset values can expand when the underlying money supply is on the way up, but will collapse if they're used to their constant fix of strong money creation. The markets suffering monetary denial are in the delirium and tremens of valuation withdrawal.

"Financial panics" are recessions by an older name

Think of the terms we use. "Credit crunch" and "overextension" are good examples. At the height of the Japanese monetary boom in the late 1980s, a few parcels of land in downtown Tokyo were supposedly worth more than the entire U.S. economy. When the tide of Japanese money creation receded, real estate and stock market values have plunged and stayed down ever since. The Japanese are only now rapidly expanding their money supply, in the hopes of staving off the effects of collapsing asset values on their frail banking system. Before the development of modern national accounting, which created the whole concept of Gross National Product or "GNP" (the dollar value of all goods and services produced by a country) as "the economy" we referred to economic setbacks as "financial panics". No neat and tidy concepts such as the current "two quarters of negative real growth". Real pit of the stomach, sweaty, blind fear. Of losing asset value. Everyone for one's self.

You'll be hearing lots of commentary on the positives of monetary tightening in the months ahead. That it means eventual lower inflation and should therefore increase stock and bond values. That it ensures a continued recovery. That long rates will decline even though short rates will rise. You'll know better. Less money will not be good for financial asset values. We heard the same arguments in early 1994 just after the Fed tightened. By the end, we had 30% declines in the value of long term bonds in both the U.S. and Canada and steep setbacks in both stock markets. Sure we'll get to the other side of the monetary hill, but we've probably got a long, hard and terrifying climb ahead of us. Forewarned, you'll be prepared when there is no hope on the horizon. Knowing that eventually money supply will expand once again, you will hold on to your long-term assets against the terrifying market retreat that seems set never to end. You'll also be ready to deploy your short-term money into very cheap stocks and bonds when no one else is buying.

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