The original meaning of inflation.
Originally, the term "inflation" wasn't specifically linked to rising prices, like those measured by the Consumer Price Index (CPI). Instead, it referred to the increase in the money supply within an economy, which can lead to higher prices under certain conditions. In this context, iQUANT will present a bullet-point analysis to assess the current state of the money supply in the United States, particularly focusing on the US M2 Money Supply.
What is m2 money supply?
M2 is a measure of the money supply that encompasses a broader range of financial assets compared to M1. It's instrumental in forecasting inflation and economic growth.
Components of M2:
M1: The most liquid forms of money, including:
Currency: Physical cash in circulation.
Demand deposits: Checking accounts.
Other checkable deposits: Interest-bearing checking accounts.
Savings Deposits: Savings accounts and money market deposit accounts.
Small Time Deposits: Certificates of deposit (CDs) under $100,000.
Retail Money Market Funds: Mutual funds that invest in short-term debt securities available to the public.
Recent Trends in m2
Rapid Growth: Since 2009, the M2 increased by over 160%, reaching around $21.5 trillion. This growth was driven by actions taken to support the economy after the 2008 financial crisis and the COVID-19 pandemic.
Stabilization: In recent months, M2 growth has slowed, remaining around $21 trillion. This potentially suggests that the rapid increase in money supply has tapered off.
M2 and Recession Prediction
M2 measures the broader money supply and can indicate a potential recession when its growth rate slows or contracts. This often signals reduced economic activity, less lending, and lower consumer spending. However, relying solely on M2 to predict a recession is insufficient. As illustrated in the chart, there have been periods when M2 growth coincided with a robust stock market and healthy economy. Therefore, other factors and measurements must also be considered.
Key Factors and Measurements to Consider:
M2 Growth Rate:
Example: Before the 2008 financial crisis, the growth rate of M2 slowed significantly, indicating tightening liquidity and economic stress.
Yield Curve:
Definition: The yield curve shows the difference between long-term and short-term interest rates.
Inversion: An inverted yield curve, where short-term rates are higher than long-term rates, has historically been a reliable predictor of recessions.
Example: The yield curve inverted in 2006-2007 before the 2008 recession.
Consumer Confidence Index:
Definition: Measures the confidence of consumers in the economic prospects.
Significance: Declining consumer confidence can lead to reduced spending and slower economic growth.
Example: Consumer confidence dropped significantly in 2007-2008, preceding the recession.
Unemployment Rate:
Significance: Rising unemployment can indicate weakening economic conditions and reduced consumer spending.
Example: Unemployment began to rise in late 2007, signaling the onset of economic troubles.
Industrial Production:
Definition: Measures the output of the industrial sector, including manufacturing, mining, and utilities.
Significance: Declining industrial production can indicate reduced economic activity.
Example: Industrial production fell sharply in 2008 as the recession took hold.
Housing Market Indicators:
Significance: The housing market is a critical component of the economy, influencing consumer wealth and spending.
Example: The housing market collapse in 2007-2008 was a major factor in the recession.
Example of Combined Indicators pointing to a recession:
2008 Financial Crisis:
M2 Growth: Slowed significantly before the recession.
Yield Curve: Inverted in 2006-2007.
Consumer Confidence: Dropped sharply in 2007-2008.
Unemployment: Began to rise in late 2007.
Industrial Production: Fell in 2008.
Housing Market: Collapsed, triggering widespread economic distress.
How This may Apply to Our Current Situation
Let’s take a look at each of these indicators today.
Slowing Growth Rate:
The current slow growth rate of M2 suggests that the economy might be experiencing reduced liquidity. Historically, a slowdown in money supply growth has preceded economic recessions, indicating reduced lending and spending. This pattern is evident when comparing the current data to past economic downturns, like the 2008 financial crisis.
Yield Curve:
The yield curve, another important recession predictor, has recently shown signs of inversion. This means that short-term interest rates are higher than long-term rates, typically signaling that investors expect slower economic growth in the near future.
Consumer Confidence and Spending:
Declines in consumer confidence and spending compound the issue. With slower money supply growth, consumers tend to be more cautious with their spending, leading to reduced economic activity and growth.
Unemployment and Housing:
Rising borrowing costs and higher mortgage rates can slow the housing market. This, coupled with businesses being more cautious in their hiring due to tighter liquidity, could lead to higher unemployment rates, further stressing the economy.
Current Production Statistics:
Recent industrial production data indicates a slowing trend. For example, the latest reports from the Federal Reserve show that industrial production has been flat or declining in recent months, reflecting reduced manufacturing output and overall economic activity.
Conclusion
The recent stabilization of the US M2 Money Supply could have significant implications for stocks and bonds when considered alongside other indicators such as Industrial Production, Housing, the Yield Curve, and Consumer Confidence.
In the stock market, sectors like retail and consumer goods may face challenges as reduced liquidity can lower consumer spending. On the other hand, more essential sectors like utilities and healthcare might perform better as investors look to be defensive during uncertain times.
For the bond market, the slower growth in M2 can lead to lower inflation expectations, which might cause bond prices to rise and yields to fall. This makes high-grade bonds a potentially attractive option for investors seeking steady returns.
In the broader economy, unemployment could rise as businesses become more cautious about hiring due to tighter liquidity conditions. Sectors such as technology and essential services may continue to show resilience, while those that rely on high consumer spending and borrowing could face difficulties.