By Tim Courtney, Chief Investment Officer
Today, we're diving into a market measure that historically has been quite important to central banks because of its potential to hamper growth (if it is too low) and to cause inflation (if it is too high): money supply. For decades U.S. money supply, measured by M2, grew at a steady pace.1 M2 essentially tracks the cash in circulation, including what's held by the public and in short-term bank deposits. Its movement is a bellwether for various economic conditions, including inflation and liquidity.
Historically, a growing money supply signaled a growing economy and/or a looser monetary policy. This typically meant central banks were allowing money into the economy to promote growth. Conversely, a shrinking or slowly growing money supply indicated a shrinking economy and/or efforts to curb inflation or cool down an overheated economy. Central banks are supposed to control money levels to manage inflation and encourage growth. This doesn’t always happen though.
The Federal Reserve in the Depression allowed our money supply to shrink by one-third, causing our economy to shrink by one-third, and prices to fall by one-third.2 In retrospect, the Fed should have increased the money supply to counter the economic destruction3. They learned that lesson though, and since have generally erred on the side of increasing money supply, which had a hand in causing the inflation of the 1970s.4
Fast forward to the COVID-19 pandemic where we saw a unique response from central banks globally, drastically increasing the money supply to counter economic shutdowns.5 The massive influx of money aimed to counteract the shutdowns caused a spike in money supply well above the trend line. These actions are part of why we're still grappling with high inflation rates today, despite resolved supply chain issues and a return to normalcy in many sectors.
As we’ve discussed, this surge in money supply also fueled investments in speculative markets. The low-interest environment of 2021 saw a significant chunk of capital flow into areas offering little to no tangible value, like certain technology and healthcare ventures, or even cryptocurrencies like Dogecoin. This trend took a pause in 2022 as the money supply's growth halted and interest rates climbed, but it has resumed recently. This large chunk of liquidity remains in markets and is affecting labor prices, goods prices, and asset prices.
For investors, this means staying disciplined, and planning for a level of inflation that may last above the 2% target for longer. As this excess money eventually gets absorbed by a growing economy, prices should begin to normalize. This could take years to work through however. Our strategy remains focused on sustainable growth and being disciplined on prices and the fundamentals that drive those prices.
If you have any questions, please reach out to your Exencial advisor.
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Federal Reserve Economic Data (FRED) is an online database consisting of hundreds of thousands of economic data time series from scores of national, international, public, and private sources created and maintained by the Research Department at the Federal Reserve Bank of St. Louis.