Money Supply Shrinks for the First Time. What It Means for a Recession.

Text size

The Federal Reserve faces a momentous decision in the coming weeks. Markets expect the central bank to raise rates by a quarter of a percentage point, marking a significant slowdown in the pace of its history-making hikes.

The dial-back, if implemented, will be for good reason — the rate increases seem to be starting to work. The annual pace of inflation cooled in December for six straight months and looks set to continue to decline.

There is another sign that the Fed’s rate hikes are working: The amount of money in the economy decreased in December. The growth of M2—a measure of the money supply in the economy that includes currency in circulation, balances in retail money market funds, and savings deposits, and more—had been slowing during the last two years after a strong increase in 2020, but in December the numbers show a decrease.

The money supply growth rate for December was negative at 1.3% compared to a year ago, the lowest ever and marked the first contraction in M2 based on all available data . The Fed began tracking the metric in 1959. November growth was already at 0.01%, well below the peak of 27% growth in February 2021.

The decline points to a cooling economy and a strong pass-through of higher rates, one that appears to be fueling recent recession fears. A sharp economic downturn, however, is not what the metric is pointing to. M2 is still 37% higher than it was before the pandemic even though it went through one of its sharpest decelerations. In other words, the amount of liquidity in the system remains high, economists say, a sign that more must be done to normalize the economy.

“The houses are still sitting on a lot of these [2020] deposits,” says Viral Acharya, former deputy governor of the Reserve Bank of India and current professor of economics at NYU Stern, referring to the stimulus controls that led to an increase in bank deposits in 2020.

That’s not the only reason M2 has risen—and it’s falling fast. For this, we can look at the actions of the Fed’s balance sheet. “Quantitative easing,” or bond buying, by the Fed during the pandemic has helped shore up the economy and the central bank’s balance sheet, pushing it to nearly $9 trillion. Now, the Fed is reducing its total assets with so-called quantitative tightening, which is reducing liquidity.

MORE Must-reads on Economics

The Fed’s total assets fell 5.3% on January 18 from last year’s peak, but the balance sheet remains more than double the $4.1 trillion in February 2020 before the start of the pandemic. That’s a lot of money, but the Fed doesn’t want to risk upsetting financial markets by going faster with tightening.

The Fed “doesn’t want to convert monetary tightening into an episode of financial instability,” said Acharya, who along with three other economists published a paper in August titled Why Shrinking Central Bank Balance Sheets is an Uphill Task.

Ultimately, as M2 retreats further it should continue to help cool inflation as the decline in money reserves dampens demand and reduces the ability to support bank lending and other financing for households, firms, and financial market transactions,” said Nathan Sheets, Citi’s global head. an economist.

But investors should not assume that the decline of M2 automatically indicates an economic slowdown, writes Richard Farr of Merion Capital Group. M2 “needs to fall by at least another trillion dollars,” to even matter, he said.

That’s a long way.

Write to Karishma Vanjani at [email protected]