The Federal Reserve will keep markets updated on US money supply levels on Tuesday, providing a crucial clue to the inflation path and the central bank’s upcoming interest rate decision.
The money supply, measured in M2, is a sum of currencies, coins and savings held by banks, balances in retail money market funds and more. This broader classification of money in the financial system came into the limelight earlier this year after contracting for three straight months on an annual basis – an unprecedented streak since the data was first introduced in 1959. December marked M2’s first year-on-year contraction . followed by a 1.75% drop in January and a 2.4% drop in February to $21.1 trillion, the biggest fall in money supply on record.
How much M2 will fall is debatable, but few doubt it will fall again. Morgan Stanley strategist Michael Wilson wrote this month that M2 is likely to “fall sharply” due to recent stress in the banking sector. Citi Global Economist Robert Sockin recently told Barron’s that he sees the contraction continuing “for many more months into the future.” Economic forecasting firm Oxford Economics estimates a 2% decline in M2 in 2023 from 2022.
Another consecutive decline in M2 in March would provide further evidence that inflation should cool further and likely influence the Fed when it sets interest rates at its May 2-3 monetary policy meeting.
The amount of money in the financial system is one of many critical factors for inflation. To put it very simply: the less money there is in the economy, the less money is left for the banks for lending and for businesses and consumers to borrow and spend. This in turn depresses prices and helps cool the economy.
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“It’s a clear positive signal for their fight against inflation,” Sockin said, although it’s “not enough for them to declare their fight over.”
Consumer prices have continued to fall steadily with the Fed’s nine straight rate hikes since March 2022. Inflation rose 5% on an annualized basis in March 2023, slowing from the pace of 6% in February and a peak of 9% in June 2022. However, it is still well above the Fed’s inflation target of 2%.
“Lack of money supply should take care [inflation]’, Vincenzo Inguscio, a London-based volatility strategist at Nomura Holdings wrote in a note last month. His calculations, based on past data, show that inflation follows the money supply pattern with a two-year lag, he said in emails to Barron’s. Morgan Stanley’s Wilson, however, predicts this inflation a year behind M2.
The upcoming March data will also be the first look at US money supply since the turmoil in the banking sector unsettled investors worldwide. The collapse of Silicon Valley Bank and Signature Bank
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in March triggered a widespread sell-off in regional bank stocks, raising questions about the health of the entire financial system in an era of higher interest rates. Panic among banks could be another factor contributing to a likely contraction in money supply last month due to a drop in bank deposits.
In the latest data available, the Fed’s report showed deposits falling 6% over the weekend April 12 to $17.2 trillion compared to a year ago. Deposits have declined year on year since November, edging slightly from the highest level of $18.2 trillion recorded in April last year.
According to Citi’s Sockin, the impact of bank-related stress will be more pronounced later in the year, particularly as credit tightens. This will result in less lending, meaning fewer and fewer deposits will be needed to support credit growth. “And that will lead to less M2.”
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Another force pushing M2 lower is the Fed’s own actions. In May 2022, the central bank announced a plan to passively shrink its assets by allowing securities to “roll off” or mature without reinvesting much of the capital received, thereby reducing liquidity. The Fed’s balance sheet has shrunk by 3.6% since the middle of last year.
Chair Jerome Powell said at a news conference in March the program was having its intended effect and the central bank saw no need to change it just yet.
“And that, in turn, would mean that US money supply growth is likely to face continued headwinds this year,” JP Morgan strategist Nikolaos Panigirtzoglou said, referring to a note issued in February Process of quantitative tightening
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The Fed’s hawkish approach marks a marked shift in policy from the pandemic era, when the Fed’s bond-buying program, government stimulus controls and the extension of generous corporate credit boosted the economy, leading to a record 27% increase in money supply in February 2021 to 19.6 trillions of dollars. Now that stimulus is largely over and M2 has contracted in turn.
But it’s important to remember that even with a tightening of the money supply, there is still a lot of cash lying around in the American financial system.
At $21.10 trillion in February, M2 was still almost $6 trillion above pre-pandemic levels, provided more than adequate levels of liquidity and was likely still fueling some inflation, including increases in car insurance prices, air fares , household items and other items march. Shelter took the top spot, up 8.2% over the past year.
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“M2 growth absolutely has an impact on inflation, but it works with a long lag,” Wilson said.
For now, the fall in M2 appears to be helping the Fed fight inflation, but could pose a problem longer term. In a note earlier this month, independent economist Steven Anastasiou warned of a possible deflationary collapse in the US if there were further significant declines in M2 in the future.
The hope for now is that sustained moderate contractions can help lower inflation without pushing the economy into deflationary territory. Whether that is possible remains to be seen.
Write to Karishma Vanjani at [email protected]
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