The amount of money sloshing around the U.S. economy shrank last year for the first time on record, a development that some economists believe bolsters the case for U.S. inflation pressures continuing to abate.
The Federal Reserve’s main measure of the nation’s money stock – known as M2 money supply – slid for a fifth straight month in December, dropping by a record $147.4 billion to a seasonally adjusted $21.2 trillion from the month before, data from the U.S. central bank released this week showed.
From a year earlier, the volume of cash, coins, checking and savings deposits, other small time deposits and cash parked in money market funds fell by nearly $300 billion and has fallen by more than $530 billion since last March when the Fed kicked off its aggressive – and ongoing – process to drain liquidity from the economy to combat high inflation.
M2 took off in March 2020 as the Fed slashed rates and started buying trillions of dollars in bonds to help support the economy as the coronavirus pandemic started, ultimately mushrooming by $6.3 trillion – a 40% increase – from its level right before the start of the crisis.
The recent decline in the money supply comes as the Fed has been aggressively raising rates to push inflation back to its 2% target. Since last June, it has also cut its holdings of Treasury and mortgage bonds by $400 billion to roughly $8.5 trillion to augment that process, further stripping the economy of financial liquidity.
Money-supply purists have long argued that the country’s ever-growing stock of money was an inflation powder keg. It’s an argument that lost credibility with policymakers in the record-long economic expansion before the pandemic when M2 rose by more than 80% but inflation never rose sustainably above the Fed’s 2% target and spent much of that decade notably below it.
That dynamic changed in the last two years, though, with money supply trends moving in roughly the same direction as inflation pressures: As money supply rose rapidly into early 2022, so did inflation; since M2 started a persistent decline last summer, inflation pressures have also receded.
Some Fed officials are now taking 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 this month. “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 sure, measuring money supply is complicated, with no one way to do it. The Fed itself has altered its approach, scrapping the publication of an even broader measure, called M3, in 2006.
Bullard, acknowledging the cooling off of money supply, said this downshift in money “bodes well for disinflation,” which means the Fed is likely to face an enduring trend of lower price pressures.
A paper published this month by the Mercatus Center at George Mason University said that economists and policymakers would do well to keep an eye on money supply measures in the future.
“Money has all but disappeared from monetary policy analysis” given the economics profession’s emphasis on the view monetary policy works by managing expectations about the future path of interest rates, wrote Joshua Hendrickson of the University of Mississippi. Given money supply’s better-than-expected track record on recent inflation issues, ignoring these numbers has been “misguided,” he said.
Economists, meanwhile, are still taking on board whether money supply is something they need to pay greater mind to as they contemplate monetary policy and inflation.
“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 appears the Fed’s aggressive balance sheet expansion during the pandemic did have a bigger impact on inflation relative to recent decades.