Federal Reserve Asset Sales & Money Supply Growth (M2)
Back in December 2017 I wrote an article titled "The Math Behind Quantitative Tightening - Why It Will End Early." In this article, I outlined why the pace of Federal Reserve tightening was too aggressive and why it would lead to a choppy equity market in 2018. Here's an excerpt from that post which you can find here:
The Federal Reserve has laid out a pace of reducing the balance sheet or contracting the monetary base by $10 billion per month and increasing to $50 billion per month by the end of 2018. Given their pace, the average reduction is roughly $30 billion per month.
Given the money multipler of 3.55, a $30 billion dollar reduction in the monetary base will reduce the money supply by just over $100 billion per month, assuming the money multipler holds constant.
The money supply is currently increasing at a pace of roughly $50 billion per month. This rate of monetary tightening is going to cause a rapid decline in the money supply.
The growth rate in the money supply is already contracting due to rapid contractions in bank loan growth.
Money Supply Growth:
The growth rate in the money supply (M2) has been under severe pressure since the Federal Reserve has started tightening monetary policy.
If the Federal Reserve continues to tighten monetary policy at the pace that they have laid out, the money supply growth will contract to nearly 0% by the end of 2018.
Money Supply Growth With Estimated Federal Reserve Tightening:
Given that M2 Growth + Money Velocity Growth= Nominal GDP Growth, shrinking M2 will cause nominal GDP growth to fall.
M2 Growth + Velocity Growth = Nominal GDP Growth:
I followed that post up with an article at the end of January titled "Quantitative Tightening Is Right On Schedule." In that post, I updated the growth rates of money supply growth and reiterated that the pace of tightening was too fast. Here's an excerpt from that post which you can find by clicking here:
Assuming the money multiplier holds flat, the rate of M2 growth can be estimated using a multiplier of 3.55.
Estimated Path of M2:
With these numbers, the year-over-year rate of M2 growth can be calculated to obtain half the GDP equation in Fisher's equation of exchange (M2 Growth + Velocity Growth = GDP Growth).
Year over Year Growth in M2:
The chart shows that by the end of 2018, the rate of M2 growth is nearly negative. The rate of M2 growth has already been decelerating sharply since the end of 2015 when the Federal Reserve started raising rates, noted by the black line in the chart above. These assumptions show the rate of money supply growth to simply continue lower. A continuation puts M2 growth near zero by the end of 2018. It is for these reasons that GDP growth, while up several quarters in a row, will not be able to rise to a high nominal rate. This additional monetary tightening in the form of asset sales is going to severely impact nominal GDP growth unless there is an offset in velocity. Velocity growth year over year has been negative for 27 consecutive quarters.
Velocity Growth Year over Year:
Velocity has been increasing, still negative, yet increasing over the past few quarters. Perhaps this trend continues but to assume a high growth rate in velocity is premature in my opinion. The factors that are responsible for weak velocity, including high levels of debt, low levels of productivity growth, and worsening demographic trends are still present if not getting worse.
The offset in velocity will not be enough to counter the downward drag in GDP caused by the slowdown in M2 growth. It is more likely the increase in velocity is part of a normal bounce off easy comparisons similar to 2014-2015 and 2009-2010. The growth of Nominal GDP in 2018 should be lower than the growth in 2017.
Year-Over-Year GDP Growth:
Currently, as the Federal Reserve continues to unwind the balance sheet, money supply growth is contracting rapidly. The declines in M2 growth will cause slower growth in Q1. Given the current data, GDP for Q1 could fall below 2% on a Q/Q annualized basis. Growth with a 1 handle is a far different conversation than 3% growth.
Federal Reserve Balance Sheet:
M2 growth has fallen down to 4.0%. Given that year over year GDP growth is equal to M2 growth + Velocity growth, the contraction in M2 growth by default gives you a weaker starting point for nominal GDP.
M2 Year-Over-Year Growth:
Money supply growth (M2) continues to plunge at an even faster pace than in my previous forecasts above.
The stock market is beginning to price in the reality of slower growth. Interest rates have seemingly bottomed with (TLT) reaching a low on February 21. There are even some market pundits and forecasters who have started to notice growth slowing data. To be fair, there were really not any strong data points (aside from ISM and PMI survey data which I don't find as useful as hard economic data) for the January reporting period.
The market knows growth is slowing and Wall Street is starting to catch on too.
Bloomberg reported growth is slowing with proof in this interview: "Ecri's Achuthan Says Tariffs May Be More Bark Than Bite."
Source: Bloomberg | Click Here For Entire Video
The only one who has shown no signs of acknowledging the growth slowing data is the Federal Reserve. All the members of the Federal Reserve seemingly want to increase the pace of monetary tightening without addressing the collapsing rate of money supply growth.
Most recessions begin because the Federal Reserve is too aggressive with monetary policy at the end of a business cycle, causing an inversion of the yield curve and a credit crunch.
It seems this time is no different. I continue to forecast that the Federal Reserve will realize this toward the second half of 2018 and slow down the pace of monetary tightening. The market (SPY) will see this prior to the Federal Reserve. With the yield curve dangerously close to an inversion, one more policy mistake can start the countdown clock to the next recession.