US M2 Money Supply Concerns

The money supply in the U.S. is shrinking fast, with an update Tuesday showing the biggest drop in the growth rate ever. It offers a crucial clue to the path of inflation and the central bank’s coming interest-rate decision.

M2 Money Supply

Money supply, measured by M2, sums up currency, coins, and savings deposits held by banks, balances in retail money-market funds, and more. Data for March released Tuesday afternoon showed a negative growth rate of 4.05% versus a year ago, the biggest year-over-year decline on record. That’s nearly double the 2.3% drop experienced in February and more than twice January’s 1.62% fall.

The U.S. money supply is currently experiencing its most significant decline since the 1930s, which is causing concerns for the economy and financial markets. The decline has been ongoing since December, which is unprecedented in modern times and suggests that investors should be wary of potential weakening growth, asset prices, and inflation.

This trend can be attributed to several factors, such as the reversal of liquidity generated by post-pandemic fiscal and monetary stimulus, the Federal Reserve’s quantitative tightening, falling bank deposits, and weak demand for credit. As a result, it indicates that the Fed has no need to raise interest rates further, and it may even need to consider cutting rates.

The Fed Data

The Federal Reserve’s data from Tuesday showed that the M2 money supply, a benchmark measure of cash and cash-like assets in the U.S. economy, dropped by 2.2% to $21.099Tln  in February from the same period a year earlier. In seasonally-adjusted terms, it fell by 2.4% from the same month last year to $21.063Tln.

The March failures of Silicon Valley Bank and Signature Bank, both in the top 25 banks in the country, further aggravated concerns over a credit crunch. This led to temporary emergency liquidity measures and backstops from the Fed worth hundreds of billions of dollars, exacerbating market volatility.

According to Matt King, an expert on capital flows and liquidity at Citi in London, the M2 is a driver of broader asset price inflation, consumer inflation, equities, and real estate. He suggests that its negative signal for all of these areas could contribute to broader economic weakness.

The growth rate of money has been slowing since early 2021 due to the fiscal and monetary policies introduced to combat the pandemic, and it contracted in December 2021 for the first time since the 1940s.

Money supply as a tool Vs Interest Rates

Despite its significance, money supply has not been a central focus of policymaking for the past 30 years, as interest rates have been the preferred tool for controlling inflation. However, the surge in stimulus spending and the Fed’s tightening efforts, including rate hikes and quantitative tightening, have impacted liquidity in the system.

Deposits at smaller and regional banks have been decreasing, potentially reducing lending and affecting the M2 money supply. Furthermore, money market funds, which form part of M2, have been experiencing significant inflows. However, the money market fund flows make up a considerable portion of the over $2Tln  in funds parked daily in the Fed’s overnight reverse repo facility. As a result, a significant portion of the money in the system is stagnant. This trend aligns with the weakening demand for credit and the tightening of lending standards. Lawrence Goodman, the founder and president of the Centre for Financial Stability, warns that investors should pay attention to money supply as it sends signals about the economy’s state. He suggests that given the falling money supply and inflation, the Fed should stop raising rates.

The surge in M2 money supply in 2020 was significant and necessary, but it also led to inflation, which prompted the need for monetary tightening. With less money being handed out in Washington, inflation is likely to decrease. It’s possible that by the end of 2023, the Fed may be more concerned about the economy than inflation.

Although the Fed claims that there is no strong connection between money supply growth and inflation, the recent 26.9% increase in M2 in February 2021 is twice the amount seen during the three inflation spikes in the 1970s and early 1980s, which only reached the low teens.

The digitization of the U.S. economy has prevented inflation from being as high as it was in the ’70s, but supply chain issues during COVID made inflation inevitable. While inflation may have been lower without these bottlenecks, it still would have been higher than pre-COVID due to the large influx of government cash into the system.

According to S&P, the decrease in money supply is playing a role in the slowdown of inflation by reducing the amount of cash available to spend on goods and services. This decrease, along with other tighter monetary conditions, is contributing to the current downward pressure on inflation, although a robust labor market and rising prices for services are countering these effects. “The recent decline in M2 is certainly contributing to the decline in inflation, along with other factors such as falling energy and shelter costs that are cooling,” said Deutsche Bank research analyst Luke Templeman. “These structural economic factors will continue to push down inflation next year.”

During the pandemic, M2 was boosted by the Federal Reserve’s quantitative easing and government stimulus programs. While this provided much-needed liquidity for businesses, it also flowed into the broader economy, including nearly $931 billion in direct payments to individuals through the end of 2021. The total stock of M2 increased from $19.373Tln  at the start of 2021 to a peak of $21.740Tln  in March 2022. While it is now declining, it still has a long way to go to return to levels more in line with GDP. M2 jumped from 70% of GDP to 90% and is now back to 84%.

Despite the drop in M2 supply, there are indications that inflation may persist longer than initially anticipated. According to Michael Crook, the chief investment officer at Mill Creek Capital Advisors, the decline in M2 should result in disinflation or deflation. However, the increasing velocity at which money is exchanged in the economy is offsetting this effect. Crook believes that velocity is too unstable to accurately forecast changes in M2.

While inflation generally corresponds to M2, it is not a perfect indicator, and inflation may take longer to subside. In particular, services inflation, which is being driven by higher labor costs, may be reluctant to fall despite the strong labor market. Although the cost of goods is decreasing, the rising costs of labor are being passed on to rents and the prices of services.

Market Intelligence economists predict that the increases in rent and service costs will eventually reverse, but higher wages may have a longer-lasting impact on inflation. “What we’ve seen is wages have picked up, labor prices have picked up and inflation has. I wouldn’t call it a wage-price spiral, we haven’t completed the loop, but we’re getting close,” said Matheny.

Critically speaking even a marginal decline in money supply can do to an economy with relatively high inflation, such as the U.S. is experiencing right now. If there’s less money in circulation as prices climb, something eventually gives.

There could be a sharp slow down in buying activity and weakness in pricing power, including energy commodities, such as oil and natural gas.

Since 1945, the stock market hasn’t reached a bottom before the National Bureau of Economic Research actually declaring a recession. If M2 portends a deflationary/recessionary period is forthcoming, it would mean equities are not near their lowest levels yet. Other periods of Money Supply Contraction other than 2023:
– Great Depression 1929
– Depression of 1921
– Panic of 1893
– 1870s Banking Crisis
All previous situations had unemployment rate north of 10% and massive bank failures.


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