The amount of money sloshing around the U.S. economy reduced in 2022 for the first time on record, a development that some economists believe boosts the case for U.S. inflation pressures continuing to recede.
Interestingly, the Federal Reserve’s key measure of the country’s money stock – known as M2 money supply – dropped for a fifth successive month in December, falling by a record $147.4 billion to a seasonally adjusted $21.2 trillion from the prior month, according to data from the U.S. central bank published this week.
From a year earlier, the volume of coins, cash, checking and savings deposits, other small time deposits and cash put in money market funds slid by almost $300 billion and has dropped by more than $530 billion since last March when the Fed began its aggressive – and ongoing – process to drain liquidity from the economy to curb high inflation.
M2 took off in March 2020 as the Fed lowered rates and began purchasing trillions of dollars in bonds to help buoy up the economy as the coronavirus pandemic started, ultimately increasing by $6.3 trillion – a 40% jump – from its level right before the beginning of the crisis.
The recent drop in the money supply comes as the Fed has been aggressively hiking rates to drive inflation back to its 2% target. Since last June, it has also reduced its holdings of Treasury and mortgage bonds by $400 billion to almost $8.5 trillion to augment that process, further taking away the economy’s financial liquidity.
Money-supply purists have long asserted that the nation’s ever-growing stock of money was an inflation time bomb. It’s an argument that lost credibility with policymakers in the record-long economic growth before the pandemic when M2 increased by more than 80% but inflation never surged sustainably above the Fed’s 2% goal and spent much of that decade, particularly below it.
That dynamic shifted in the last two years, though, with money supply trends going in almost the same direction as inflation pressures: As money supply increased sharply into early 2022, so did inflation; since M2 began a persistent fall last summer, inflation pressures have also abated.
‘A Monetary Phenomenon’
Several Fed officials are now showing renewed interest.
M2 “exploded during the pandemic, and correctly predicted that we would get inflation,” Federal Reserve Bank of St. Louis President James Bullard, an early proponent of policy tightening, said earlier in January. “Inflation is certainly a monetary phenomenon” and “when you get a huge movement in money, then you do get the movement in inflation,” as was seen in the 1960s, ‘70s, and ‘80s.
To be certain, measuring money supply is difficult, with no one way to do it. The Fed itself has changed its approach, canceling the publication of an even broader measure, called M3, in 2006. Bullard, acknowledging the cooling off of money supply, said this decline in money “bodes well for disinflation,” which implies the Fed is expected to face a continuing trend of lower price pressures.
A paper released in January by the Mercatus Center at George Mason University said that policymakers and economists would do well to keep tabs on money supply measures in the future.
Buy Crypto Now“Money has all but disappeared from monetary policy analysis” given the economics profession’s focus on the view monetary policy works by dealing with expectations about the future path of interest rates, wrote Joshua Hendrickson of the University of Mississippi. Given money supply’s higher-than-expected track record on recent inflation issues, dismissing these numbers has been “misguided,” he said.
Economists, meanwhile, are still taking into account whether money supply is something they need to pay more attention to as they contemplate inflation and monetary policy.
“I think that what we are finding is that the relationship between changes in the money supply and inflation is far less linear” than had been previously understood, said Thomas Simons, economist with investment bank Jefferies.
Nevertheless, Simons said, it seems the Fed’s aggressive balance sheet expansion during the pandemic did have a greater impact on inflation than in past decades.
