Monetary Policy & Inflation | US
Marshallian K Turning Negative Conveys No Additional Threat To Markets
- By Dominique Dwor-Frecaut
- 3 min read
Summary
- The Marshallian K turning negative yoy has been seen as a negative signal for markets, even though it simply reflects the stabilization of M2 velocity, previously in free fall.
- Since Q1 2021, the main driver of the slowdown in M2 growth has been the flattening monetary base caused by Fed attempts to control both money’s price and quantity.
- This does not signal a fundamental change to the market outlook as the economy remains stuck in a TINA regime
Market Implications
- ST positive bonds, LT negative bank stocks
M2 Growth Slows
Since end-Q1, M2 has flattened (Chart 1). This mainly reflects a marked slowdown in the growth of bank deposits and a decline in retail money market fund (MMF) assets. The zero-rate environment is behind the latter, making it difficult for MMFs to compete with banks that offer convenience and relationship-based services that MMFs lack. By contrast, the growth of currency in circulation has continued apace.
Because the slowdown in M2 has been accompanied by a pick up in GDP growth, M2 velocity, that was in free fall since the pandemic started, has recently stabilized (see chart 2). The inverse of broad money, the Marshallian K, has therefore turned negative yoy, following a spike earlier in the pandemic. This has led some market participants to argue that the Marshallian K turning negative was a bearish signal. In this note I look under the hood of the M2 slowdown and argue that a negative Marshallian K is not a source of concern.
Slower M2 Growth Reflects Monetary Policy Inconsistencies
In my view, the M2 growth slowdown is mainly due to the monetary base slowdown (i.e., currency and bank reserves, which banks need to conduct their business), which is itself driven by the growing Fed RRP uptake.
Since end-March, the RRP uptake has increased by about $1tn from zero. That has absorbed the liquidity created by a decline in the TGA and asset purchases representing $0.5tn each. The RRP uptake has been growing even when the RRP rate was zero because of the liquidity created by the bond purchases that brought the GC RRP rate below zero (Chart 7).
By the June FOMC meeting, the RRP uptake was 0.5tn. After the Fed raised the RRP by 5bp at the meeting, RRP uptake doubled to $1tn. The Fed’s desire to keep expanding its balance sheet and maintain the fed funds in the middle of the target band is what led it to raise the RRP rate and resulted in slower growth of the monetary base. Even with paying interest on reserves, there are limits to the Fed’s ability to control both the quantity and price of money.
Market Consequences
Market participants concerns over the “Marshallian K” turning negative rest on the precedents of the 2010 and 2018 sell offs. In my views these concerns are unfounded for 3 main reasons.
First, the 2010 selloff was driven by fears over the sustainability of the recovery and the 2018 selloff by fears that nominal GDP was moving to a higher range where the Fed would no longer have to rely on QE to support the economy. The Marshallian K turning negative ahead of the 2010 and 2018 selloffs was likely more correlation than causation.
Second, while banks bid for Treasuries have been important, Treasury issuance is about to decline as the budget deficits falls from 14% of GDP in FY2021 to about 5% in FY2022. And with world FX reserves rising as central banks resist currency appreciation, official sector demand for Treasuries is rising.
Third, the bigger driver of market performance in my view is whether the economy remains in a TINA regime, my base case scenario, where headline growth and inflation are mediocre but low bond yields, the Fed put, and limited headline macro risks still make equities the least bad of investment choices. In 2010 and 2018 the market selloffs were followed by strong recoveries.
On the margin the ongoing slowdown in M2 could be positive for bonds and stocks since it will likely reassure investors concerned by inflation risks.
This analysis also has long term negative implications for bank stocks since it shows the difficulties banks are having conducting basic banking business, i.e., collecting deposits and making loans. These difficulties reflect the regulatory burden, monetary policy crowding out loans by stuffing banks with reserves and an overbanked US economy that are unlikely to change anytime soon.