The Implosion In U.S. M2: Less To It Than Meets The Eye – April 24, 2023

A just-published report updated our view on the short- and long-term prospects for global financial markets, concluding that the choppy tactical risk-on phase was likely to persist, but in the context of a late-cycle bearish backdrop due to a maturing expansion and sticky DM underlying inflation.

The report also addressed the issue of the sharp decline in U.S. M2 money supply, which is seen by many as a harbinger of economic recession and disinflation. We disagree.

M2 money supply has contracted 2% over the past year, however, two other measures of the money supply, namely the level of real M2 and M2 relative to GDP, remain high compared with their pre-pandemic trends. Proponents of the view that M2 signaled that there would be a huge increase in inflation and now indicate an impending recession and sharp fall in inflation are mixing causation. The growth in M2 didn’t cause the surge in inflation, rather unprecedented and massive fiscal transfers to households and ongoing solid income growth enabled consumers to increase spending. Combined with the supply constraints of the pandemic shutdowns, that spending created inflation. Had consumers not spent the money they received, there would not have been the surge in inflation. In sum, inflation was the result of excessive spending, not the mere increase in deposits.

The flipside is now occurring. Once the flow of fiscal payments stopped it was almost inevitable that the growth in household deposits that are included in M2 would also reverse. Households are drawing down on their excess deposits (savings) accrued during the pandemic to support spending, although they still have an historically sizable pile remaining and personal income is still growing at a decent clip. That drawdown in savings and deposits is the source of the decline in M2.

In short, swings in demand are the key variable in driving inflation trends. The swings in M2 reflect the unusual fiscal injections into the household sector and subsequent drawdowns, but are not the cause of inflation nor will it be the “cause” of the next recession.


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