M2 Contraction – Neither Recession nor Disinflation

Summary

• The ongoing M2 contraction reflects a combination of excessive deposit creation during the pandemic, quantitative tightening (QT), and the weak credit growth typical of early-stage recoveries, rather than a recession.
• The M2 contraction is unlikely to reduce inflation as it is partly offset by increased money velocity, and money growth is only one of many factors keeping inflation high and stable.

Market Implications

• The Federal Reserve (Fed) and markets are overestimating 2024 rate cuts.

M2 Swings Reflect QE/QT and Credit Demand

In this note, I argue that the ongoing M2 contraction reflects QT and the weak demand for credit typical of an early recovery. I also show that there is no stable, long-term relationship between M2 growth and inflation and that the current M2 contraction is unlikely to reduce inflation.

M2 comprises currency, bank deposits, and money market funds (MMF), with bank deposits representing about 80% of the total. Changes in deposits have driven recent changes in M2 (Chart 2).

What drove the expansion in banks deposits during the pandemic? It was initially quantitative easing (QE) that increased bank reserves and deposits. 

The other, much more normal mechanism through which banks create deposits is when they make a new loan and credit the deposit of the borrower accordingly (for a detailed explanation of how banks create money, see this Bank of England primer).

Banks’ capacity to expand their deposit base is largely driven by monetary policy. During the pandemic, the Fed maintained ultra-loose policy in the face of weak credit demand. As a result, banks’ balance sheets expanded, but banks purchased securities rather than gave new loans because credit demand was weak (Chart 3).

The Fed started QT in mid-2022, which saw a decline in both banks’ reserves and deposits. In addition, as credit demand recovered, banks sold their securities holdings to make room for the expansion of their loan books. As a result, banks’ post-pandemic credit expansion only had a limited impact on deposit growth.

And since end-2022, bank loans have been flat, partly because a decline in Commercial and Industrial lending has offset growth in consumer and real estate lending (Chart 4).

Slower credit growth is typical of the early stages of recoveries, when borrowers take advantage of income normalization to repay the debts accumulated during the recession and rebuild their balance sheets.

Finally, another possible contributor to the ongoing deposits contraction is excess deposit creation during the pandemic, which itself reflected unprecedented Fed easing. Relative to households and corporate holdings of financial assets, bank deposits are higher than before the pandemic (Chart 5). Similarly, relative to disposable income and profits, households and corporate holdings of bank deposits are higher than before the pandemic.

Overall, the ongoing contraction in broad money is unlikely to reflect an ongoing or incipient recession, but rather excess bank deposit creation during the pandemic as well as QT and slowing credit growth. In short, economic normalization. 

At the same time, the M2 contraction is unlikely to reduce inflation.

M2 Contraction Unlikely to Slow Inflation

M2 growth turned positive MoM in May, the latest data point available (Chart 6). Based on weekly bank deposits and MMF asset data, MoM M2 could be positive in June too. Longer term, though, a recovery in M2 growth is unlikely until QT ends or credit demand rises.

However, a continued M2 contraction does not imply an inflation slowdown. The complex relationship between inflation and money growth has broken down since the mid-1990s (Chart 7). Since then and until the pandemic, money growth has been in a 5-10% range while inflation has remained around 2%.

The breakdown between money growth and inflation is often explained by the decline in the velocity of money, which is an implicit reference to the ‘monetarist’ equation.

MV=PQ

Here, ‘M’ is the quantity of money, ‘V’ is the velocity, ‘P’ is the price level, and ‘Q’ is real activity.  The equation is an accounting identity, since V adjusts so that the left-hand side of the equation equals the right-hand side. It does not imply anything about the causal relationships between the components M, V, P, or Q.

What explains the decline in the velocity of money since the late-1990s?  What V actually describes is the change in nominal GDP associated with an increase in money (i.e., in bank deposits). The decline in velocity of money reflects largely the secular decline in banks’ loan-to-deposit ratio – i.e., the declining efficiency of the banking system (Chart 8).

The fall in the loan-to-deposit ratio in turn reflects, in the runup to the GFC, an increase in other assets (mainly trading assets), as large banks moved away from their traditional role of allocating savings to the real economy and instead engaged in speculative market activities (Chart 9). 

Post-GFC, the Fed’s new operational framework, together with regulatory tightening, has saddled banks with large quantities of cash and securities that have lowered the loan-to-deposit ratio. In effect, the post-GFC monetary and regulatory framework has weakened banks’ ability to channel savings to the real economy (for a full discussion of the inconsistencies and inefficiencies of the abundant reserves monetary policy framework see the BIS paper, Getting Up From the Floor).

Short term, however, the continuation of QT will lower banks’ cash holdings and raise the loan-to-deposit ratio and therefore the velocity of money, which will partly offset the contraction in the stock of money. 

This is not to say that money growth plays no role in inflation. Inflation reflects a persistent imbalance between supply and demand. To the extent that money growth is funding demand for goods and services, it is a contributor to the imbalance, alongside fiscal policy and other macro factors such as a the wage-price feedback loop.

Market Consequences

This discussion suggests that market fears of an imminent recession and market hopes for immaculate disinflation are unfounded. The M2 contraction reflects the Fed’s extreme easing during the pandemic, followed by QT and weak credit demand. It is likely to last but alone is unlikely to reduce inflation, as the velocity of money is rising, and other factors are keeping inflation high. 

The markets have now nearly priced out 2023 Federal Funds Rate (FFR) cuts, but are expecting 150bp cuts in 2024. Meanwhile, the Fed expects to cut 100bp in 2024. Both are likely to be disappointed.

Dominique Dwor-Frecaut is a macro strategist based in Southern California. She has worked on EM and DMs at hedge funds, on the sell side, the NY Fed, the IMF, and the World Bank. She joined Macro Hive soon after its inception.

(The commentary contained in the above article does not constitute an offer or a solicitation, or a recommendation to implement or liquidate an investment or to carry out any other transaction. It should not be used as a basis for any investment decision or other decision. Any investment decision should be based on appropriate professional advice specific to your needs.)