Money Supply Squeeze

While we are eclectic on money supply relationship with growth/inflation, but it cannot be ignored and the recent sharp deceleration warrants investigation in the U.S. and Eurozone.

Figure 1: U.S./China/Eurozone M2 Growth (Yr/Yr %) 

Source: Datastream/Continuum Economics 

Slow U.S. and EZ Money Supply Growth 

M2 growth in the U.S. and the Eurozone has slowed sharply into 2023 in the U.S. and the Eurozone (Figure 1), due to two main reasons. 

• QE to QT. The sharp increase in money supply growth in 2020 came from the exceptional QE operations at the height of the initial COVID crisis, with the Fed and ECB creating huge amount of reserves and boosting money supply. QE of course has ended and the Fed has ramped up to substantive QT, which is reversing the effects of the money stock and reducing money supply growth. The ECB is taking a measured approach to APP QT in 2023, but reserves will still be reduced by the roll off of the massive EUR1.5trn TLTRO’s for 2023 and this will likely be a factor continuing to slow EZ M2 growth. M1 growth rates have slowed more sharply than M2 growth rates reflecting this force. China has not had QE or QT in the last few years.
• Slowing lending growth into 2023.U.S. C&I loans and advances have shown strong momentum in 2022, after repayment of loans in 2021 had seen a negative trend. The Fed loan officer survey suggests that corporate and household loan conditions is tightening into 2023. Additionally, the weekly mortgage applications have plunged as mortgage rates have surged through 2022. EZ corporate lending growth has slowed, but residential lending has been more resilient, but with all aspects of private credit falling in real terms at unprecedented rates. However, the ECB credit conditions survey shows tightening conditions for the supply of credit and ebbing demand, which likely translates into further slowing of lending growth through 2023. China in contrast has directed the banking system to sustain loan growth to be consistent with nominal GDP aspirations and this has seen lending growth remains consistent in 2022 and this will likely remain the case in 2023.

Practical economists are biased towards dismissing the role of money in its relationship with growth and money, as the missing part of the puzzle is falling velocity of money (Figure 2). After the global financial crisis, U.S. M2 velocity fell for structural reasons as the banking system undertook a dramatic shift in equity and liquidity to shore up balance sheets and this slowed the velocity of money and policymakers argued that healthy money growth was required as a counterbalance and avoid nominal GDP being destabilized. The 2020 plunge in velocity needed the same surge in money supply to avoid a shock to nominal GDP growth, with a sharp precautionary increase in the demand for money due to the huge uncertainty at the time. One argument is that 2020 is different from 2008-09, as the world did not suffer a banking and financial crisis and that post COVID a rebound in velocity should be seen and this means that current falling M2 growth is not a major cause for concern.

Figure 2: U.S. M2 Velocity of Money (Yr/Yr %) 

Source: Datastream/Continuum Economics 

Continuum Economics has an eclectic view on money and we would not describe ourselves as monetarists. Nevertheless, we would include money and credit flows as part of our broader framework in analyzing growth and inflation prospects and accepting the uncertain feedthrough of money supply growth to GDP growth and inflation. In the U.S. this is also complicated by the key role that capital markets undertake in raising finance for the U.S. economy, which is not captured by M2 growth. But in the EZ, there is clear correlation between credit growth and HICP inflation, where the softening in the former adds to confidence that price pressures are receding.

We would take the view that current M2 growth and the prospect of a further slowdown are consistent with long and short leading indicators that are included in our EZ and U.S. recession forecasts for 2023 in the December Outlook (here) and also a slowdown in inflation trends back towards target in 2024. Though the percentage magnitude of tightening has been seen in the past, the pace in 2022 was very quick and also the proportionate shock to borrowers is large given the low financing costs that existed 2009-2021.

Figure 3: Real U.S./China/Eurozone M2 Growth (Yr/Yr %) 

Source: Datastream/Continuum Economics 

From a nominal GDP standpoint, money supply trends in the U.S. and EZ suggest a slowdown relative to 2022. Though this is what central banks are trying to achieve, the pace of nominal and real money supply slowing is sharp (Figure 1 and 2) and money needs to be seen alongside other indicators in making an assessment for the economy. Traditional transmission is normally seen in real activity slowing and then inflation and this is certainly the sequencing we are looking for through 2023 and 2024.