Trading Signals 05/02 – 09/02
Deciphering U.S. M2 Money Supply and Its Impact on the Economy
The M2 money supply is a key indicator of economic trends, with changes in its volume providing insights into potential inflationary patterns. Recently, there has been a notable contraction in M2 — a phenomenon not seen since 1959.
Here’s an explanation of what this signifies, how M2 compares with similar indicators, and why broader metrics aren’t always as useful.
Recent Developments
The Federal Reserve reported that in December 2022, the money supply stood at $21.207 trillion, marking a 0.67% decrease from November 2022.
M2 is a measure of the money available within an economy. It’s a significant indicator of monetary liquidity, showing the amount of spendable cash that businesses and consumers have at their disposal.
Components of M2 include cash, traveler’s checks, savings deposits, time deposits, liquid securities, and money market funds.
The Federal Reserve is responsible for calculating M2 on a monthly basis.
Other Money Supply Metrics
Other measures of money supply include M1, M3, and M4. Each measures the amount of money in the economy but varies in scope. M1 includes only cash and checkable deposits, representing a narrower money volume than M2.
M3 adds to M2 by including large corporate deposits and their liquid instruments, such as short-term debt securities.
M4 is the most expansive, incorporating all of M3’s components plus less liquid financial instruments, like long-term deposits and debt obligations.
Interestingly, gold is not factored into these metrics, as it is no longer the global standard of currency. Nonetheless, gold plays a vital role in maintaining the stability of a nation’s currency due to its liquidity.
Though not the most comprehensive, M2 is closely watched by economists for its economic implications.
M2 is broader than M1 yet more adaptable. When a company moves money from a money market fund to its own bank account, M1’s total volume rises since money market funds aren’t included in M1, leading to a nominal increase in money.
With M2, the same action doesn’t change the overall money supply because M2 accounts for money market funds. Significantly, M2 adjusts with the main population’s expenditures, whereas M3 and M4 include financial instruments that are less volatile.
Given that approximately two-thirds of the US GDP is generated by internal demand, M2, which indicates the condition of consumer finances through available cash and deposits, enables us to more promptly monitor changes in the American economy. Additionally, M2 is tallied monthly, in contrast to M3’s quarterly calculation. While M1 is also assessed monthly, the Federal Reserve does not measure M4 in the US—this indicator is used in England and some other nations.
M2 Money Supply Shifts Signal Economic Directions.
Shifts in the M2 money supply act as a barometer for the U.S. economy’s movements.
An uptick in M2 could presage a wave of consumer spending, potentially kickstarting business growth as companies scale up to cater to increased demand.
However, a bulging M2 doesn’t necessarily signal an economic boom. It’s often seen swelling in economic downturns when U.S. authorities enact rate cuts and pump money into the economy, offering a financial lifeline to both enterprises and the populace.
During the financial crisis of 2009-2011 and the subsequent pandemic years, the M2 money supply ballooned as the Federal Reserve slashed interest rates and flooded the economy with capital. This influx of liquidity, a result of the Fed’s extensive bond purchases from financial institutions, enabled banks to offer loans at historically low rates in a policy move known as quantitative easing. The graph of M2 during the pandemic is particularly striking, illustrating the government’s direct financial support to individuals and businesses during the periods of strictest lockdowns.
As interest rates begin to climb, consumer behavior shifts towards saving rather than spending, and banks reallocate funds into less liquid assets such as long-term deposits and bonds. This transition results in a reduction of the readily available money supply, which could presage a downturn in consumer and business expenditure. Such a trend often precedes a cooling of inflation rates and, in some cases, may signal the onset of a recession.
The recent downtrend in M2 suggests that the Fed’s strategy of incremental rate hikes is yielding the desired effect, steering the economy towards a reduction in spending that aligns with its inflation control goals. The Fed’s approach reflects a balancing act: too much money in circulation can lead to inflation, while too little can stifle economic growth. By adjusting the interest rates within a targeted range, currently set between 4.75% and 5%, the Fed aims to temper spending just enough to keep inflation in check without triggering a recession.
In conclusion, the Fed’s monetary policy maneuvers, particularly the manipulation of the M2 money supply, are a delicate dance of economic stimuli and restraints. While the recent contraction in M2 indicates a potential easing of inflationary pressures, it also serves as a reminder of the Fed’s pivotal role in shaping the economic landscape. As the U.S. navigates through these inflationary times, the Fed’s policies will continue to be instrumental in either softening or exacerbating the economic swings, with global repercussions that extend far beyond American borders.
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