Positive Economic Commentary

Real M2 - The Rodney Dangerfield Of Leading Indicators
March 01, 2002

Psst! Can you keep a secret from the gold'n-them-there-sacks economic brain trust on Wall Street? Real M2 growth once again has proven to be an excellent leading indicator of domestic aggregate demand. While the golden boys are adding a mortality-perception component to their financial conditions index, real demand in this economy is recovering faster than they can revise up their forecast. For reasons unbeknownst to me, real M2 is the Rodney Dangerfield of leading indicators among the majority of economists - both inside and outside the Fed. It just doesn't get any respect. Should it get any?

I'll let you be the judge. Plotted in the chart below is the year-over-year percent change in real M2 versus the year-over-year percent change in real final sales to domestic purchasers starting in 1960. Real M2 growth is advanced by two quarters to see if its behavior leads that of real final sales to domestic purchasers. The box in the upper left corner of the chart contains the correlation coefficient between the two series, with real M2 growth leading by two quarters. That correlation coefficient is 0.71 out of a possible 1.00 - an outstanding result for government work, and not too shabby for private sector work, either.

Keeping in mind that real M2 growth is advanced by two quarters, the chart clearly shows that the slowdown in real M2 growth presaged the slowdown in the growth of real final sales to domestic purchasers. Real M2 began growing faster early in 2001. It, therefore, is "predicting" that growth in real final sales to domestic purchasers should be turning up soon. And, in fact, if you look closely to the last real final sales data point plotted in the chart, you will see a slight uptick in it.

Notice in the chart that in the recessions (designated by the shaded areas) between 1970 and 1990, real M2 contracted. Although its growth did begin slowing in 1999, subsequent to that, real M2's year-over-year percent change did not dip below zero. In fact, it has never even gotten close to zero in recent years. But notice too that although growth in real final sales to domestics began slowing in 2000, it did not slow to the extent that it has in past recession. This is consistent with the signals being sent by real M2 growth - weaker demand but not of sufficient magnitude to be associated with a recession. One wonders that if it had not been for the economic disruptions caused by the September 11th terrorist attacks whether the US economy would have sunk into an official recession.

Real M2 growth certainly is not a perfect leading indicator. Probably M2's worst performance was in the early 1990s, when its contraction was suggesting that the Recession that started in 1990 would not end in 1991, as it did. Of course the recovery that did start in 1991 was the weakest in the postwar period. But let's not let the perfect be the enemy of the good. Real M2 growth consistently has given good guidance about the future behavior of domestic demand. Moreover, it has not been necessary to put the M2 model in "drydock" for modification after each cycle. Can the same be said for the consistent accuracy and lack of modification of those high-falutin' financial conditions indices (FCIs).

So, when trying to predict what aggregate demand will do, just keep this thought in mind - if the Fed prints it, we will spend it.

Paul Kasriel
Director of Economic Research

The information herein is based on sources which The Northern Trust Company believes to be reliable, but we cannot warrant its accuracy or completeness. Such information is subject to change and is not intended to influence your investment decisions.

[an error occurred while processing this directive]