With recent stock market gains, it might seem like we’re in the clear from a recession. The S&P 500 is up over 20% from the lows in October 2022 and over 15% year-to-date.
Before we can officially declare that the “up only” train is back on track, there are a few data points that we need to consider. One of the big ones is the contractions of the U.S. money supply — or the fact that there is now less money in circulation.
The money supply has recently fallen by a historical amount, and in the past, this signaled an upcoming change in the market. Let’s dive into the details of the U.S. money supply, how it has changed recently and what it means for the overall economy.
What Is the US Money Supply?
The U.S. money supply is measured in various ways, but the most common are called the “M1” and the “M2” money supply.
The M1 money supply measures the most accessible forms of money like cash, coins and checking account deposits, as well as traveler’s checks. In other words, the M1 money supply is the equivalent of cash circulation.
The M2 money supply measures takes the M1 money supply balances and adds in savings accounts, certificate of deposit (CD) accounts (under $100,000 balance) and money markets funds. The M2 money supply is considered slightly less accessible, as you might have time delays on withdrawals or other hurdles to overcome to access the cash.
Current State of the US Money Supply
The U.S. money supply increased at a rapid pace in 2020 and 2021 due to the pandemic and large government stimulus packages that supplied individuals and businesses with new money. This caused an increase of the M2 money supply from around $15 trillion to a peak of nearly $22 trillion in 2022.
The influx of business stimulus and direct checks sent to hundreds of millions of Americans caused a massive spike in the U.S. money supply, which in turn, caused a spike in prices. With the new money flooding the economy, inflation was rampant, hitting over 9% year-over-year in June 2022.
To combat this inflation, the Federal Reserve raised interest rates (which were at zero) quickly. This has had its intended effect — slowing spending and lowering inflation quickly — but this also means there is less money available overall. In addition, the Fed has started removing liquidity from the economy through Quantitative Tightening (QT), further reducing the M2 money supply.
Recently, the M2 money supply has shrunk from a high of $21.7 trillion in July 2022 to $20.8 trillion in May 2023. This 4.1% reduction in M2 money supply in under a year can have a big impact on the economy going forward.
What Does an M2 Money Supply Reduction Mean?
Historically, a reduction in the M2 money supply isn’t common, and in fact, there hasn’t been a reduction in the M2 money supply year-over-year since 1933. And while we live in a different age these days, there are some historical indicators that show a reduction in money supply has preceded a huge economic event.
According to data from Reventure Consulting CEO Nick Gerli, a meaningful reduction in the M2 money supply (2% or more) has only happened four times since 1870, and each time it has proceeded a depression with double-digit unemployment.
According to Gerli, when the money supply is reduced during periods of inflation, this means there are fewer dollars in the economy to pay for higher-priced goods and services. This reduction causes “deflation,” which can hurt businesses, leading to layoffs and ultimately a stock market crash.
This “deflationary depression” happened in the 1870s, 1890s, 1921 and the Great Depression. A depression hasn’t happened in nearly 100 years, partly due to the creation of the Federal Reserve and evolution of our monetary policy. But this doesn’t mean we won’t see a downturn in our economy as inflation remains high and spending continues to slow.
Are We Headed for a Recession?
In short, according to the money supply data, there is a strong possibility of a recession in the United States. With high interest rates, reduced money supply and slowing consumer spending, this points to a slowing in overall growth in the economy.
A decline in the gross domestic product (GDP) over two consecutive quarters defines a recession, and while this hasn’t happened yet, there is a high likelihood it will happen soon.
The U.S. government and Federal Reserve are also highly aware of the devastating effects of a recession and will do everything in their power to balance the fight with inflation with avoiding a recession. A temporary pause in rate hikes has already spurred an increase in stock prices, and if a recession looks inevitable, there may be reason to lower rates and pause QT in order to spur economic growth.
All that to say, an economic recession looks likely, but monetary policy can change quickly in an attempt to avoid it, so it’s hard to say whether it will happen or not.
Other Signs That Point to a Possible Recession
Outside of money supply, there are other indicators of a possible recession in the United States.
- Inverted Treasury Yield Curve. Bond yields are probably the most reliable recession indicator around. Specifically, when shorter-duration bonds have a higher yield than long-duration bonds, this is known as an inverted yield curve. This has accurately predicted the last 10 recessions and has been inverted since July 2022.
- Commercial Credit Reduction. There has been nearly a 2% reduction in commercial bank credit over the past few months (though it is still up year-over-year). A reduction of over 1.5% in commercial bank credit has only happened a few times in the recent past, most notably in 2002 and 2008, which coincided with a massive drop in the stock market.
- Trade and Manufacturing Sales. According to data from the St. Louis Fed, while sales held strong in 2022 amidst high inflation and interest rate hikes, there has been a reduction in trade and manufacturing sales over the last few months. It’s too early to call it a meaningful reduction, but keep an eye on the numbers.
The money supply is shrinking right now, and this can spell bad news for the overall economy. High prices paired with less money available for spending means growth will slow, which can lead to a recession. While the U.S. government and Federal Reserve are doing their best to avoid a recession, even members of the Fed admit it’s a strong possibility that we have one before inflation is tamed. But with strong unemployment numbers and consumer spending standing still, it’s hard to tell when (or if) it will happen this year.
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