The Federal Reserve (Fed) faces a momentous decision in the coming weeks. Markets expect the central bank to hike rates by 25 basis points, which would mean a significant slowdown from its historic pace of hikes to actively combat inflammation.
The reduction in the rate of increases, if carried out, will be for a good reason: it seems that the rate hikes are starting to work. This was stated this week, for example, by the Bank of Canada, anticipating the Fed. The annual rate of inflation in December fell for six consecutive months and it seems that it will continue to slow down.
Also, another sign that the Federal Reserve’s rate hikes are working: the quantity of money in the economy contracted in December. The growth of M2 – a variable that measures the money supply in the economy that includes liquidity in circulation, balances in retail money market funds and savings deposits, among others – had slowed in the last two years after a rebound in 2020, but December figures show a decline.
December’s money supply growth rate was negative at 1.3% from a year ago, the lowest ever and the first decline in M2 (money supply) based on all available data. The Fed began tracking this indicator in 1959.
The drop points to a cooling off in the economy and a strong pass-through from the rate hike, which would seem to fuel recent recession fears. However, the indicator does not point to a sharp economic decline. The aforementioned M2 is still 37% higher than it was found before the pandemic, despite suffering one of its steepest slowdowns. In other words, the amount of liquidity in the system remains high, economists say, a sign that there may be more room to normalize the economy.
“Households are still sitting on much of these deposits [del 2020]says Viral Acharya, a former deputy governor of the Reserve Bank of India and current professor of economics at NYU Stern, referring to the stimulus checks that led to an increase in bank deposits in 2020.
The other reasons and the level of danger
But that’s not the only reason M2 skyrocketed – and has been falling rapidly. To do this, we can look at actions on the Fed’s balance sheet. “Quantitative easing,” or bond buying, by the Fed during the pandemic helped boost the economy and the central bank’s balance sheet, pushing it to almost $9 trillion. of dollars. Now the Fed is cutting its total assets through so-called quantitative tightening, which is reducing liquidity.
The Fed’s total assets were down 5.3% on January 18 from last year’s high, but the balance sheet is still more than double the $4.1 trillion it was in February 2020, before the start of the pandemic. That’s a lot of money, but the Federal Reserve doesn’t want to risk upsetting financial markets by accelerating tightening.
The Fed “doesn’t want to turn monetary tightening into an episode of financial instability,” says Acharya, who along with three other economists published an article in August titled “Why Shrinking Central Bank Balance Sheets Is an Uphill Task.”
Ultimately, as M2 continues to recede, it should continue to help cool inflation, as declining monetary reserves reduce demand and diminish “the ability to support bank lending and other types of financing for households, businesses and financial market transactions,” says Nathan Sheets, Citi’s chief global economist.
Still, investors shouldn’t take for granted that falling M2 will automatically signal an economic slowdown, according to Merion Capital Group’s Richard Farr. “M2 has to drop at least another trillion dollars for it to matter,” he says. He remains with an attentive look.