M2 Money Supply Is Set to Contract Again. What It Means for the Fed, Economy, and Inflation.

https://www.barrons.com/articles/m2-money-supply-fed-inflation-262c7234

The Federal Reserve will update markets on the amount of U.S. money supply on Tuesday, offering a crucial clue to the path of inflation and the central bank’s coming interest-rate decision.

Money supply, measured by M2, is an aggregate of currency, coins, and savings deposits held by banks, balances in retail money-market funds, and more. This broader classification of money in the financial system entered the spotlight earlier this year after contracting on an annual basis for three straight months—an unprecedented streak since the data was first introduced in 1959. December was M2’s first year-over-year contraction ever, followed by January’s 1.75% fall and February’s 2.4% decline to $21.1 trillion, the steepest drop in money supply yet.

Just how much M2 will fall is a matter of debate, but few doubt it will decline again. Morgan Stanley strategist Michael Wilson wrote this month that M2 is likely to “fall sharply” with the recent stress in the banking sector. Citi Global Economist Robert Sockin told Barron’s recently that he sees a continued contraction for “many more months forward.” Economic-forecasting firm Oxford Economics estimates a 2% drop in M2 in 2023 from 2022.

Another consecutive decline in M2 in March would provide more evidence that inflation should continue to cool and likely influence the Fed when it sets interest rates at its May 2-3 policy meeting.

The amount of money in the financial system is one of many critical factors for inflation. Very simply put, the less money there is floating around in the economy, the less there is for banks to lend and for companies and consumers to borrow and spend. In turn, that pushes down prices, helping cool the economy.

“It’s a clear positive signal for their fight against inflation,” said Sockin, although not “enough for them to declare their fight is over.”

Consumer prices have continued to fall steadily with the Fed’s nine consecutive interest-rate increases since March 2022. Inflation rose 5% in March 2023 on an annual basis, decelerating from February’s 6% pace and the June 2022 peak of 9%. It still, however, remains much higher than the Fed’s target inflation rate of 2%.

“Lack of money supply should take care of [inflation],” Vincenzo Inguscio, a London-based volatility strategist at Nomura Holdings wrote in a note last month. His calculations, based on past data, show inflation follows the money supply pattern with a two-year lag, he said in emails to Barron’s. Morgan Stanley’s Wilson, however, predicts that inflation lags one year behind M2.

The coming March data will also be the first look at the U.S. money supply since the banking sector turmoil unnerved investors globally. The collapse of Silicon Valley Bank and Signature Bank in March triggered a widespread selloff in regional bank stocks and raised questions about the health of the overall financial system in an era of higher interest rates. The panic among banks could be another factor that contributes to a likely contraction in money supply last month thanks to a decline in bank deposits.

For the most recent data available, Fed’s report showed deposits were down 6% for the week ending April 12 to $17.2 trillion versus a year ago. Deposits have been falling year-over-year since November, off slightly from the highest-ever $18.2 trillion level seen in April last year.

The impact of the banking-related stress will be more pronounced later in the year, according to Citi’s Sockin, especially as credit tightens. That’ll lead to extending fewer loans, which means there’s less and less need for deposits to back loan growth. “And that’s going to lead to less M2.”

Another force pushing down M2 is the Fed’s own actions. In May 2022, the central bank announced a plan to passively shrink its assets by letting securities “roll off,” or mature, without reinvesting much of the principal received, thereby reducing liquidity. The Fed’s balance sheet has declined 3.6% since the middle of last year.

Chairman Jerome Powell in a March press conference said the program is achieving its intended effect and the central bank doesn’t see the need to change it yet.

“And in turn, this would mean that U.S. money growth would likely face a continued headwind this year,” J.P. Morgan JPM +0.14% strategist Nikolaos Panigirtzoglou said in a note issued in February, referring to this process of quantitative tightening

The Fed’s hawkish approach marks a stark shift in policy from the pandemic era when the Fed’s bond-buying program, government stimulus checks, and extension of generous business loans, worked to juice the economy, leading to a record 27% surge in money supply in February 2021 to $19.6 trillion. Now those stimulus measures are largely over, and M2 has shrunk in turn.

But it’s important to remember that even with money supply contracting, there is still a whole lot of cash sitting around in America’s financial system.

At $21.10 trillion in February, M2 was still nearly $6 trillion higher than prepandemic levels, offering a more than adequate level of liquidity and likely still fueling some inflation including increases in prices for motor vehicle insurance, airline fares, household furnishings, and other items in March. Shelter grabbed the top spot, up 8.2% over the past year.

“M2 growth absolutely has an impact on inflation but it works with a long lag,” Wilson said.