The Federal Reserve faces a momentous decision in the coming weeks. Markets expect the central bank to raise interest rates by a quarter of a percentage point, marking a significant slowdown in its historic rate of increase.
The rollback, if implemented, will be for good reason – the rate hikes look what they are begins to work. The annual rate of inflation in December cooled for six consecutive months and looks set to continue to ease.
There’s another sign that the Fed’s rate hikes are working: The amount of money in the economy fell in December. Growth in M2 – a measure of the amount of money in the economy that includes currency in circulation, retail money market fund balances and savings deposits and more – had been slowing over the past two years after a rise in 2020, but December figures show a decline.
Money supply growth for December was negative at 1.3% from a year ago, the lowest on record and marks the first-ever decline in M2 based on all available data. The Fed began tracking the metric in 1959. November growth was already at 0.01%, well below the peak of 27% growth in February 2021.
The decline points to a cooling economy and a strong impact from higher interest rates, which appear to be feeding recent recession fears. However, a strong economic decline is not what the metric signals. M2 is still 37% higher than it was before the pandemic despite going through one of its sharpest decelerations. In other words, the amount of liquidity in the system remains high, economists say, a sign that more needs to be done to normalize the economy.
“Households are still sitting on many of these  deposit,” says Viral Acharyaformer deputy governor of the Reserve Bank of India and current professor of economics at NYU Stern, referring to the stimulus checks that led to a surge in bank deposits in 2020.
That is not the only reason why M2 rose – and has fallen rapidly. For that, we can look at the Fed’s balance sheet actions. “Quantitative easing,” or bond buying, by the Fed during the pandemic helped squeeze the economy and the central bank’s balance sheet, pushing it to nearly $9 trillion. Now the Fed trims its total assets by so-called quantitative tightening, which is reduce liquidity.
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The Fed’s total assets fell 5.3% as of Jan. 18 from last year’s peak, but the balance is still more than double the $4.1 trillion in February 2020 before the start of the pandemic. That’s a lot of money, but the Fed doesn’t want to risk the financial markets going up by going faster with the tightening.
The Fed “does not want to convert monetary tightening into an episode of financial instability,” said Acharya, who along with three other economists published a paper in August with the title Why shrinking central bank balance sheets is an uphill task.
Ultimately, as M2 retreats further, it should continue to cool inflation as the decline in monetary reserves squeezes demand and lowers “the capacity to support bank lending and other financing for households, businesses and financial market transactions,” it said Nathan Sheets, Citi’s global head. economist.
But investors should not assume that falling M2 will automatically signal an economic slowdown, writes Merion Capital Group’s Richard Farr. M2 “has to fall by at least another trillion dollars,” he said.
There is a long way to go.
Write to Karishma Vanjani at [email protected]