U.S. Money Supply Shrinks: A Harbinger of Market Moves

The U.S. money supply has recently experienced a decline not seen since the Great Depression. This unprecedented shift, marked by a significant drop in M2, the broad measure of the money supply, has raised eyebrows and sparked debates about its implications for the stock market. The decline in M2, which includes physical currency, coins, small time deposits, and retail money market funds, has been substantial, with a drop of roughly $700 billion since the hiking cycle began. This decline is primarily due to a roughly $2.4 trillion drop in savings deposits, which has been offset by increases in other components of the money supply. The Federal Reserve has reduced its balance sheet holdings by around $800 billion, which has put pressure on savings deposits. Banks have responded to the drop in deposits by raising new funding through large time deposits, selling financial assets, and slower lending.



The recent decline in the U.S. money supply is unprecedented in several ways. Historically, the U.S. money supply has not declined at the rate it has since late 2022. According to the data, "There has been no other month of year-over-year decline in M2 since at least 1959." This decline is significant because it marks a shift from the rapid growth seen during the COVID-19 pandemic, where M2 grew at record rates from February 2020 through 2022.

Comparing this to historical periods, the decline in M2 is not only unprecedented but also follows a period of extraordinary growth. The 26.9% rate of year-over-year growth in February 2021 was the highest on record, exceeding rates during the quantitative easing programs of 2008-15 and the inflations of the 1970s and 1980s. This rapid growth was driven by factors such as precautionary holding of money by firms and individuals during the pandemic, as well as fiscal and monetary stimuli.

The insights drawn from these comparisons suggest that the current decline in M2 could have significant implications for future market movements. Historically, growth in monetary aggregates has been linked to inflation, although the relationship has been complex and influenced by various factors. For instance, the rapid growth in M2 during the pandemic was followed by a rise in PCE inflation, which peaked in June 2022. This lagged effect is consistent with Milton Friedman's "long and variable lags" explanation, where the impact of money on inflation takes between 6 months and 2 years to manifest.

Given the current decline in M2, if the historical relationship holds, we might expect inflation to follow the decline in M2, potentially returning to levels consistent with the FOMC target of 2% or even falling below this target. However, it is important to note that the relationship between monetary aggregates and economic outcomes has become less reliable due to factors such as financial innovation, changes in interest rates, and regulatory impacts. For example, the demand for reserves held by banks and other depository institutions at the Fed has increased dramatically since the financial crisis, making the volume of reserves held at the Fed larger and more volatile.



The primary factors driving the current decline in the U.S. money supply include changes in Federal Reserve policy and rising interest rates. According to Goldman Sachs Research, the decline in M2, which includes physical currency, coins, small time deposits, and retail money market funds, has been significant, with a drop of roughly $700 billion since the hiking cycle began. This decline is primarily due to a roughly $2.4 trillion drop in savings deposits, which has been offset by increases in other components of the money supply. The Federal Reserve has reduced its balance sheet holdings by around $800 billion, which has put pressure on savings deposits. Banks have responded to the drop in deposits by raising new funding through large time deposits, selling financial assets, and slower lending.

These factors are likely to influence the Federal Reserve's monetary policy decisions in the near future. The decline in the money supply suggests that higher interest rates are already capturing the information relevant for borrowing and economic activity provided by the monetary aggregates. Goldman Sachs economists suggest that a better way to estimate the impact of tighter monetary policy and financial conditions on the economy is by using market prices and interest rates rather than quantities such as M2. They point out that there is a more robust statistical link between changes in Goldman Sachs Research’s broad financial conditions index and GDP growth, which captures the effect of higher interest rates on homebuilding or the effect of lower asset prices on consumer spending.

Market prices directly influence trade-offs between consumption and savings, and they are immune to the changes in how monetary policy is implemented and other factors that can distort the link between monetary aggregates and economic outcomes. Therefore, the Federal Reserve may continue to focus on market prices and interest rates as key indicators for adjusting monetary policy, rather than relying solely on monetary aggregates like M2. This approach allows for a more nuanced understanding of the economic landscape and enables the Fed to make more informed decisions about interest rates and other policy tools.

In summary, the recent decline in the U.S. money supply is unprecedented and follows a period of extraordinary growth. Historical comparisons suggest that this decline could lead to a reduction in inflation, but the relationship between monetary aggregates and economic outcomes is complex and influenced by various factors. Therefore, while the decline in M2 provides some insights into potential future market movements, it is not a definitive predictor. Investors should remain vigilant and consider a diversified approach to navigate the evolving economic landscape.