Money Supply Lowest Since Depression

M2 money supply is contracting at an unprecedented rate. The measure, which includes cash, savings accounts, money market funds, and certificates of deposit (CDs) below $100,000, has shrunk 4.1% from an all-time high in July 2022.

So far, stock indexes have shrugged off this warning, quietly re-igniting a fresh bull market, but history shows a drop in money supply is a bearish signal. It has happened only four times in history, each time ending in a double-digit unemployment depression.

Analysts might point out that a minor contraction is a drop in the bucket compared to the 35% growth in money supply between 2020-2022. However, the relationship between depressions and deflations is not linear – meaning that a small drop in money supply can trigger a market contraction.

The closest historical parallel is with 1921 when the post-WWI money supply expansion resulted in high inflation before a 2% contraction triggered deflation and an 11% unemployment rate.

“I think that what we’re seeing right now is not alarming,” said Jeremy Piger, an expert on recession indicators and a professor of economics at the University of Oregon.

“I used to work at the Federal Reserve, and historically, maybe the single most important thing they did was regulate the quantity of money in the economy. [But] In the last 25 to 30 years, there’s been a decreased emphasis on actually paying attention to, certainly, short-run movements in the quantity of money in the economy,” Piger concluded.

Steve Hanke, a professor of applied economics at John Hopkins University, believes the Fed is on the right path to bring inflation down.

“If the Fed continues to shrink the money supply, inflation will hit the “2% range pretty fast,” said Hanke, who just finished a study (set to be published in September) showing a one-to-one relationship between changes in the money supply and changes in inflation.

A declining money supply indicates monetary integrity, but the US Dollar Index (DXY) is approx. 4.5% lower from its levels a year ago. Currently, there are two possible reasons for this weakness.

First is the structural weakening due to de-dollarization risks, and second is the forward-looking nature of the market that already anticipates rate cuts potentially as early as Q1 2024.

While the BRICS Summit on August 22 in South Africa might clarify risks to the dollar's reign, the latest rate hike failed to send the greenback higher, reflecting current sentiment.

The market expects no more rate hikes, while the FED chairman Jerome Powell insists on evaluating the situation on the go.

“We have to be ready to follow the data, and given how far we’ve come, we can afford to be a little patient, as well as resolute,” Powell noted.

“The staff now has a noticeable slowdown in growth starting later this year in the forecast, but given the resilience of the economy recently, they are no longer forecasting a recession,” he added, shifting the narrative away from the downturn which was anticipated by the FOMC March through June.