Evening Brief – 04.10.23

Rate hikes and balance sheet reductions (QT) may not be large enough to permanently reduce inflation, or at least get it back to the Fed’s 2% target any time soon, but they are shrinking the money supply and that generally means an economic slowdown ahead. In fact, growth, asset prices and inflation could all weaken.

The US money supply, which had its heyday three decades ago as a Fed policy tool, has shrunk (year-over-year) for the third month in a row, which is an historic first as it had never shrunk before, since M2 data became available in 1959.

On a seasonally adjusted basis, M2 money supply fell 2.4% in February from the same month last year to $21.063tn, which is on top of the declines in December and January.

The money supply grew at an unprecedented rate during the pandemic and the decline is largely due to the reversal of that liquidity; between April 2020 and April 2021, US money supply growth often climbed above 35% year over year.

Money supply growth can often be a helpful measure of economic activity and an indicator of coming recessions as it is a benchmark measure of how much cash and cash-like assets are sloshing in the economy. During periods of economic boom, money supply tends to grow quickly as banks make more loans. But recessions tend to be preceded by slowing rates of growth.

A declining money supply appears to be connected to an inverted yield curve. For example, the 3s/10s yield spread often heads toward zero as money supply growth moves in the same direction. This was especially clear from 1999 through 2000, from 2004 to 2006, during 2018 and 2019, and beginning in 2022.

The Fed may be confident in their tight monetary policy and the resiliency of the economy, but the downtrend in money supply growth may be a signal that the economy does not need tighter monetary policy. The opposite may be true.