An example of the aggregates’ ability to deceive

Doug Noland: A change in the marketplace’s preference for duration can have a major impact on the M’s, especially M3. A few years back I used the hypothetical example of a money market fund that held short term Fannie Mae debt instruments. With short-term rates at 1%, let’s say that fund investors came together and voted to convert to a bond fund. In this circumstance, the fund manager could simply call Fannie and negotiate a change in maturity structure on their securities (transform them from “money market instruments” to “bonds”). Such a situation would exact no change in the underlying quantity of outstanding Credit or liquidity, although “money” supply would decline (reduced money market fund assets).

Importantly, M3 is a problematic indicator of system liquidity, while it can very well give completely erroneous signals at key junctures. In particular – and as we witnessed during 2003 – when the marketplace is moving aggressively toward higher-yielding and riskier financial assets, M3 growth would be expected to badly lag underlying Credit expansion. Indeed, at critical junctures, a stagnating M3 could be perfectly consistent with liquidity overabundance in riskier asset classes. And it is worth noting that MZM (“money at zero maturity”) is an especially flawed measure of system liquidity, specifically because it includes – and is distorted by the vagaries of - money fund assets (while excluding time deposits). MZM was a good enough indicator of system liquidity when GSE balance sheet growth (and money market borrowings) was a major factor, but has become an especially poor metric the past few years.