Money Supply Shrinks at Fastest Pace Since Great Depression

The U.S. Federal Reserve building is seen past caution tape in Washington, D.C., on Sept. 19, 2022. Stefani Reynolds/AFP via Getty Images

The Federal Reserve recorded its fourth consecutive monthly contraction in the money supply as the central bank continued to remove money from the financial system.

In March, the M2—a measurement of money in circulation that includes cash, checking deposits, and a wide range of other deposits—declined 4.05 percent, down from negative 2.3 percent in February. This is the largest year-over-year percentage drop since the Fed launched the series in January 1960. The first time the Fed recorded a contraction was in December 2022, when it fell 0.9 percent.

The U.S. money supply has been on a steady decline since hitting a peak in February 2021.

Money-supply contraction is also accelerating at the fastest pace since the Great Depression, when it plunged 28 percent between 1929 and 1933, according to Census Bureau data.

In total, the country’s money stock stands at $20.818 trillion, which is still nearly 35 percent higher than at the beginning of the coronavirus pandemic.

In March 2022, the Fed established its quantitative-tightening campaign, a blend of raising interest rates and trimming its roughly $9 trillion balance sheet. This has been a critical policymaking instrument because the central bank can reduce the money supply by selling assets and changing short-term interest rates.

Does Money Supply Growth Create Inflation?

A chorus of economists will contend that the Fed’s astronomical injection of liquidity into the financial system through its unprecedented quantitative-easing program at the start of the COVID-19 public health crisis was a crucial factor in the rampant price inflation that has occurred in the last two years.

“The first step toward understanding the cause of inflation is to recognize that it is always and everywhere a monetary phenomenon,” said eminent economist Milton Friedman (in 1963). “It’s always and everywhere a result of too much money, of a more rapid increase in the quantity of money than in output.”

In the modern economy, according to Friedman, governments are in “control of the quantity of money.”

“As a result, inflation in the United States is made in Washington and nowhere else,” he said.

President of the Federal Reserve Bank of St. Louis, James Bullard, in Washington, on Aug. 6, 2019. Alastair Pike/AFP via Getty Images

Other economists, market analysts, and prominent business individuals have presented similar arguments about governments and central banks worldwide today.

James Bullard, president of the Federal Reserve Bank of St. Louis, has advocated monitoring M2 data for garnering better insights into inflation.

“M2 exploded during the pandemic and correctly predicted that we would get inflation, and now if you look at the same chart, M2 growth has declined dramatically,” he said in a January 2023 speech. “That bodes well for disinflation, but it’s actually turned negative in recent readings.”

Bullard also echoed the remarks of Friedman, calling himself a “monetarist at heart” and that “inflation is certainly a monetary phenomenon. That’s why it’s called monetary policy.”

The Bank for International Settlements (BIS) averred in a January 2023 paper that assessing money-supply growth would have allowed policymakers to improve their inflation forecasts in the immediate aftermath of the pandemic.

“A link can also be seen in the recent possible transition from a low- to a high-inflation regime. An upsurge in money growth preceded the inflation flare-up, and countries with stronger money growth saw markedly higher inflation,” BIS economists wrote. “Looking at money growth would have helped to improve post-pandemic inflation forecasts, suggesting that its information value may have been neglected.”

Tesla CEO and Twitter owner Elon Musk recently told former Fox News host Tucker Carlson that “if you increase the money supply, you get inflation.”

“There’s not some magical cure for getting rid of inflation, except to increase the productivity, the output of goods and services.”

But not everyone agrees that there is a correlation between inflation and the money supply.

Ben Broadbent, an economist and deputy governor for monetary policy at the Bank of England, for example, has argued that money supply was not the cause of inflation, explaining that price trends do not “fit the story.”

“A pure, money-driven inflation affects all prices equally,” Broadbent said at the National Institute of Economic and Social Research. “What we’ve actually seen are huge shifts in relative prices—first the jumps in those of non-energy traded goods in 2021 and then, in 2022, the enormous rises in the costs of imported food and energy.”

While it would be possible to lay out “an alternative path for monetary policy” to keep inflation in check, this would not be “the same thing as saying that the actual policy was ‘inevitably’ going to result in excessive inflation.”

Fed chair Jerome Powell said in his semiannual Monetary Policy Report to Congress in February 2021 that “the growth of M2 ... doesn’t really have important implications for the economic outlook,” adding that it is an idea “we have to unlearn.”

However, the Fed Bank of St. Louis states that “inflation is caused when the money supply in an economy grows at a faster rate than the economy’s ability to produce goods and services.”

So, during the public health crisis, there was too much money, be it from the fiscal or monetary side, chasing too few goods.

Will this decline in the money supply successfully eliminate the inflation threat?

Raymond James chief economist Eugenio J. Aleman projects that real money supply growth will need to fall by 8–9 percent year over year and “remain in negative territory for several years” to allow the Fed to accomplish its 2 percent target inflation rate.

Recession Confirmed?

More economic experts and market observers purport that the sharp contraction in the money supply will result in slowing activity and potentially a recession.

Steve Hanke, a professor of applied economics at Johns Hopkins University, thinks the Fed’s “monetary mismanagement” and the M2 contraction “means a recession is just around the corner.”

“Soft landing? No. Hard landing? Maybe,” he recently stated in a tweet.

The spread between the three-month and 10-year yields—the Fed’s preferred recession indicator—has widened to about negative 170 basis points. Economist Robert Murphy argues that a sustained drop in the money supply coincides with substantial upward movements in short-term yields.

The three-month yield is above 5.1 percent.

“When the money supply grows at a high rate, we are in a ‘boom’ period and the yield curve is ‘normal,’ meaning the yield on long bonds is much higher than on short bonds,” he wrote. “But when the banking system contracts and money-supply growth decelerates, then the yield curve flattens or even inverts. It is not surprising that when the banks ’slam on the brakes’ with money creation, the economy soon goes into recession.”

The Conference Board’s Leading Economic Index (LEI), a composite index that aggregates various indicators, such as initial jobless claims, building permits, and stock prices, is another widely watched recession gauge. The LEI plunged 1.2 percent in March and fell to its lowest level since November 2020, signaling “worsening economic conditions ahead.”

“The Conference Board forecasts that economic weakness will intensify and spread more widely throughout the U.S. economy over the coming months, leading to a recession starting in mid-2023,” said Justyna Zabinska-La Monica, the senior manager of business-cycle indicators at The Conference Board, in a statement.

The first-quarter GDP growth rate will be released on April 27. Economists are forecasting a 2 percent reading, which would be down from the 2.6 percent expansion in the fourth quarter.