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U.S. Real Money Supply Is Decelerating

Includes: SPY, TLT, VGSH, VOO
by: Jason Cawley

Year on year growth in US M2 money supply adjusted for price level changes has slowed to 1.74% year on year.

This is a significant deceleration from the long run trend rate of 3% and a more recent average around 4.5% in this expansion.

US monetary policy must now be considered objectively tight.

While recent tax cuts might counter this tendency in the near term, inflation measures could surprise to the downside over the next 1-2 years.

Year on year growth rates of US money supply measures

In an older blog post on Seeking Alpha back in October of 2012, I gave a long-term view of the growth of the US money supply in real terms and explained why I consider this a meaningful gauge of the effectiveness of US monetary policy. That blog post can be found here.

Below I will update the core graph used in that post, but above I instead show the year on year changes in the same measure, effectively the first derivative of those real value of the money supply time series. The yellow line shows the real changes in narrow M1, while the blue line shows the real changes in M2; to me, the more important of the two measures as the one more closely related to overall changes in the economy. The graph itself shows how loose the relationship between the two can be, with M1 showing much lower lows late in the last cycle while being consistently higher throughout the present expansion. This shows there is no close or necessary "gearing" or constant ratio between narrow money and broad.

Looking at the blue line, the first and second QE periods are starkly apparent. The success of the second QE period raised the real growth in M2 to around the 5% level and it has fluctuated between 3% and 5% since, until quite recently. The average rate of expansion of M2 has run 4.5% above the rate of CPI inflation over the last ten years. But over the last 12 months, that rate has fallen to 1.74%, with little change in the level since July of 2017. The next table shows the recent figures for inflation-adjusted M2, in billions of February 2018 dollars.

Recent levels of real M2

Note the similarity of the figures for July 2017 and for December 2017. Looking at weekly figures, we can expect the same level to be reached in March 2018 - the real level of M2 has basically leveled off rather than actually falling. Bear in mind that since we see M1 still increasing roughly 5% year on year in real terms, this deceleration is occurring in the non-M1 portions of M2, meaning primarily in savings accounts and CDs. This is outside money, bank supplied deposits used by the general public, not the inside bank reserve monetary base directly controlled by the Federal Reserve.

The rate of growth of real money can fall for two different reasons - because the rate of inflation rises or because the rate of deposit growth falls. The recent move is dominated by the latter, as the rate of CPI inflation has not moved by much, though it has contributed slightly to this fall.

As explained in the previous 2012 post, I regard this measure as a good indication of whether monetary policy is doing a good job or a poor one. The reasoning is that a general secular increase in the real value of the money supply is normal and desirable. The economy expands continually, and when in addition, real demand for money increases, it is possible and desirable for the monetary system as a whole to meet this demand and it adds value to do so. In my analysis, the best behavior for this measure would be to remain stable on a rising trend, or for the real growth rate to remain positive, but at a modest and sustainable level.

I next show an updated version of the original graphic showing the full series back to January 1959, for the level of real money supply rather than its recent rates of change. Here are those time series for M1 and M2:

Long run US real money supply

Adjusted for inflation, the US money supply was $2.466 trillion 2018 dollars in 1959 compared to $13.858 trillion today. This 5.62 fold increase over 59 years amounts to an average rate of increase just under 3%. It has not, however, been a completely steady increase. In some periods, inflation has run so high that the real money supply fell or failed to increase, with a stop and go pattern visible in the 1970s for example.

Whenever money grows faster than demand for it, people scramble to get rid of the money they have, so any additional "forced" circulation destroys value. Equally, when money growth is too slow, no value is added when it could be. An optimal monetary policy from this perspective keeps the real value series on a steady, increasing course, keeping pace with overall economic growth and with any rising willingness of the public to hold higher money balances.

From this perspective, US monetary policy since the "great recession" has been successful. But we are now, in just the last 6 to 12 months, entering a new period in which that real money growth is slowing significantly. The Fed stopped increasing its sheet size in the fall of 2014, began raising rates a little over a year later and has been decreasing its sheet size since September of 2017.

It might reasonably be expected that broad money growth would have continued had rates remained steady anyway, since the level of excess reserves left from the previous QE periods is so high, the commercial banks are not seriously constrained by reserve requirements. Meanwhile, the operating constraint on commercial bank expansion has instead been capital requirements, and increases in those have ceased, while bank profitability has been rising. New corporate tax cuts also promise additional increases in bank profitability, and together, these could provide for faster broad deposit growth despite Fed sheet contraction.

However, that is simply not what we are seeing in the data since last summer. While the tax changes may still take time to show up, what we have actually seen is a significant downshift in the rate of deposit growth since roughly the middle of last year. The Fed's sheet contraction and rising rates will add to that tendency. Overall, monetary policy in the US must now be considered tight, and the risks it presents are to the downside for both inflation and nominal GDP growth, not to the upside.

An optimistic counter case might stress the role of fiscal stimulus and easing capital constraints on the commercial banks, and therefore, expect higher broad money growth going forward, to counteract the Fed's tightening moves. This certainly bears watching over the next year to see what the full effects of those policy changes will be. However, so far that is not what the data are saying. Deposit growth is slowing, while accelerating inflation looks to be little or no risk in the near term. Rather than being behind the curve for the cycle, the Fed currently looks too aggressively tight.

I hope this is interesting, and as always, questions and comments are welcome below.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.