Putting Western Money Supply Dips Into Context

The Western world’s contracting money supply is garnering ever more attention amongst commentators we follow, which we are both surprised and not surprised about.^[i] Surprised, because the economic school of thought that emphasises money supply has lost significant cultural clout in recent decades, based on our observations. Unsurprised, because when sentiment is low, as we think it is now, investors tend to exacerbate anything that looks a bit gloomy. At any rate, broad money measures have been slipping for months in the US, UK and eurozone, ratcheting up recession chatter from financial commentators we follow.^[ii] Whilst we agree it is worth watching, we see some mitigating circumstances and don’t view this as reason to believe stocks’ economic drivers are weakening.

In a vacuum, we find falling money supply is typically bad news for the economy. After all, in our opinion, money creation and swift velocity (the rate at which money changes hands) are the lifeblood of new economic activity. We worded that as a general statement, but there is well over a century’s worth of data and rhetoric to back it up, and if it weren’t a copyright violation, we would take pictures of the pretty charts in Wesley Clair Mitchell’s Business Cycles and Milton Friedman and Anna Jacobson Schwartz’s A Monetary History of the United States, 1867 – 1960 and post them here to prove it. But we think they showed, with numbers, graphs and words, that rising money supply often accompanies prosperity and declining money supply usually breeds bad times.

But those statements aren’t absolutes and we think it is too simplistic to equate falling money supply with broad developed-world economic woes this time. For one, the declines are very small thus far. The US Center for Financial Stability’s M4 gauge, the broadest measure available in America, is off just -1.0% y/y—a slower pace of decline than April’s—and nearly matching eurozone M3.^[iii] UK M4 is down a bit more, -4.1% y/y, but there is some base effect skew from a two-month jump in September and October 2022.^[iv]

But also, we think context matters, and the nascent, small slip follows huge monetary spikes during COVID lockdowns—the very money supply spikes that our research shows triggered 2022’s hot inflation (broadly rising prices).^[v] The massive wall of money that monetary policy institutions pushed into the system is still there, a lasting COVID-related dislocation in the global economy.

To show this, we are going to do something we usually don’t do: show you charts with trendlines. We normally don’t use trendlines (which show the long-term growth rate as a straight line), as they imply averages have gravitational pull—not true, in our view. But in this case, we think comparing actual money supply to an extension of pre-pandemic growth rates is a good illustration of a counterfactual. Looking at the US, UK and Europe, we see that even with the nascent declines, money supply remains well above the pre-pandemic trend. In our view, this is compelling evidence that—rather than being a big negative—the declines are part of a late-lagging return to normal.

Exhibit 1: US M4 Money Supply Versus the Pre-COVID Trend

Source: Center for Financial Stability, as of 6/12/2023. Divisia M4 (index), December 2013 – October 2023.

Exhibit 2: UK M4 Money Supply Versus the Pre-COVID Trend

Source: Bank of England, as of 6/12/2023. M4 Excluding Intermediate OFCs, December 2013 – October 2023.

Exhibit 3: Eurozone M3 Money Supply Versus the Pre-COVID Trend

Source: FactSet, as of 6/12/2023. Eurozone M3, December 2013 – October 2023.

Still, we do think the situation bears watching. If the drop worsens or pairs with a lending freeze as bank funding costs rise, it could put a big strain on things. But for now at least, we don’t think that appears to be the case, and with so many eyeballs on this, surprise power is probably minimal, in our view. Markets probably started discounting it before people caught on, and they have been rising on both sides of the Atlantic.^[vi] So for the moment, we suggest simply appreciating the small monetary contraction as a force slowing inflation that, in our view, likely helps keep price rises cooler from here.