Since March, M2 growth has slowed sharply YoY (Chart 1). This reflects several factors:
A base effect from the 82% annualized increase in March-May 2020.
A stabilization of reserves that in turn reflects mainly the sterilization of the LSAPs and of the decrease in the TGA through the RRP facility.
A decline in the credit multiplier (the ratio of bank loans to reserves) that reflects limited demand for bank loans. Excluding PPP loans, the credit multiplier is even lower.
Alongside the slowdown in M2 growth, M2 velocity has been slowing. The unprecedented collapse in velocity in Q1-Q2 2020 reflected the unprecedented Fed easing and collapse in nominal GDP. Velocity recovered in Q3 2020 alongside nominal GDP, but since then, nominal GDP has grown more slowly than M2 and velocity has resumed its slide.
While velocity could stabilize with Fed tapering and a continued recovery, I expect little upside.
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Summary
- M2 velocity has collapsed, but the increase in M2 money supply has aligned with that in other financial assets.
- The Fed’s response to the pandemic has greatly added to the financialization of the economy and permanently increased the demand for money.
- This suggests limited inflation risks from higher M2 balances.
Market Implications
- Medium term, a negative inflation surprise suggests continued Fed dovishness, bond purchases, Fed put, low yields, strong risk assets and a weak dollar.
M2 Growth and Velocity Have Been Falling
Since March, M2 growth has slowed sharply YoY (Chart 1). This reflects several factors:
- A base effect from the 82% annualized increase in March-May 2020.
- A stabilization of reserves that in turn reflects mainly the sterilization of the LSAPs and of the decrease in the TGA through the RRP facility.
- A decline in the credit multiplier (the ratio of bank loans to reserves) that reflects limited demand for bank loans. Excluding PPP loans, the credit multiplier is even lower.
Alongside the slowdown in M2 growth, M2 velocity has been slowing. The unprecedented collapse in velocity in Q1-Q2 2020 reflected the unprecedented Fed easing and collapse in nominal GDP. Velocity recovered in Q3 2020 alongside nominal GDP, but since then, nominal GDP has grown more slowly than M2 and velocity has resumed its slide.
While the velocity of money could stabilize with Fed tapering and a continued recovery, I expect little upside.
The Velocity of Money’s Secular Decline Reflects Financialization
The velocity of money has been falling since the late 1990s. I think this reflects the increased financialization of the US economy since then. The collapse of velocity in the early stages of the pandemic illustrates my point. The Fed and the administration injected an enormous amount of stimulus into the economy. Yet much of it was saved (i.e., funded the purchase of financial assets) rather than spent on goods and services. Consequently, nominal GDP increased by much less than if the stimulus had been spent, and the value of financial assets, including M2, jumped – by 1.6 times nominal GDP! During the year to Q1 2021, financialization (the ratio of the value of financial assets to GDP) increased by as much as in the 11 years to 2019!
Financialization is unlikely to reverse anytime soon. Whenever markets have sold off, the Fed has tended to ease policy: it believes its policy stance is transmitted through financial conditions. Therefore, any tightening of financial conditions in theory warrants some policy easing. Also, Fed policies are asymmetric: the Fed never tries to lower financialization – the policies ignore it altogether.
Because of greater financialization, the demand for money has increased.
The Demand for M2 Money Supply Has Increased
M2 growth since the pandemic, and indeed since the GFC, has aligned with that of other financial assets. The stable share of M2 in the US’s overall financial asset mix reflects two trends that have tended to move in opposite directions. These are changes in the M2 share of safe assets (M2, Treasuries, agencies and munis) and changes in the safe assets share of all financial assets (M2, debt securities and stocks).
These trends are even more apparent with households, which hold 85% of M2 balances. The distribution of M2 holdings among households aligns with the distribution of wealth, i.e., highly concentrated: households in the top income quintile own two-thirds of M2 held by all households. Also, since the pandemic, 70% of the increase in M2 has gone to the top quintile.
Meanwhile, households in the top income quintile have increased the share of M2 in their safe assets. However, the share of M2 in their overall portfolio has been stable because the share of safe assets has declined. Since these households are financially sophisticated and can access a wide range of financial instruments, it seems plausible these changes in their portfolio composition are intentional and reflect an increase in the demand for money. This suggests M2 holdings are unlikely to fall much, i.e., there is limited upside to the velocity of money.
Market Consequences
The Fed has engineered a permanent increase in the demand for money by greatly increasing the financialization of the US economy. This suggests limited upside to M2 velocity and limited inflation risks from high M2 balances.
Short term, I continue to expect a growth slowdown as employment and nominal wage growth remain too weak to offset the recently high inflation prints and the end-of-pandemic benefits. The slowdown could pull yields down and keep equities rangebound as markets remain in a TINA regime.
FAQ
What Is M2 Money?
M2 is a component of the money supply alongside M1 and M3. Like M1, M2 includes cash and checking deposits, but M2 also includes near money (savings deposits, money market securities, and other time deposits). Economists use M2 to indicate money supply and forecast inflation.
What is the Velocity of Money?
The velocity of money is a measure of how frequently money is exchanged in the economy. Specifically, money velocity is a calculation of how many times in a given period one unit of a currency is used to purchase goods and services produced domestically.