Recession Risk Grows After Money Supply Shrinks At Fastest Pace Since Great Depression

According to recent data from the Federal Reserve, the money supply in the United States has decreased for the third month in a row and is currently declining at a rate that is the swiftest since the era of the Great Depression.

The M2 money supply, which serves as a standard to measure the amount of circulating cash, bills, bank deposits, coins, and money market funds within the US economy, experienced a decline of 2.24% in February compared to the same period the previous year. This marks a further decrease from January’s negative 1.7% and marks the third consecutive month of a contracting money supply.

Early indicators point to another contraction in March, as the M2 money supply tumbled 3.13% year over year for the week ending March 6.

As of the end of February, the total U.S. money supply was recorded at $21.099 trillion.

While the year-over-year percentage decline in the money supply has been notable, the current level remains approximately 38% higher than the pre-pandemic level.

This decline in the money supply, which began in February 2021, is a result of the Federal Reserve’s decision to reverse the liquidity injections implemented during the pandemic and reduce its balance sheet, along with a decrease in bank deposits.

Many economies across the world are also experiencing a slowdown or contraction in M1 money supply growth.

In the European Union, the M1 annual growth rate decreased by 2.7% in February from negative 0.8% in January. In the United Kingdom, the M1 growth rate slowed to 1.55% in January, while in Canada, the M1 fell for three consecutive months, dropping to 3.57% in December 2022.

Recession Confirmed?

Could this be indicative of an upcoming recession? Several economists are cautioning that the decline in money supply growth in the US and other nations is a potential signal of an impending economic downturn.

“We have not seen money supply declines like this since the Great Depression,” said Mike Shedlock, an economist and registered investment advisor for SitkaPacific Capital Management.

“The contrarian position isn’t that a recession will come later, but rather that it’s already started.”

Steve Hanke, a senior fellow at the Independent Institute and professor of applied economics at Johns Hopkins University, believes that a recession in the United States is virtually certain.

“Due to the Fed’s monetary mismanagement, the M2 money supply is falling at its fastest rate since the 1930s,” he stated.

“The QUANTITY THEORY OF MONEY tells us that, w/ a 6-18 month lag after M2 drops, economic activity will slump.”

However, there are contrasting views on the impact of the money supply on the economy, such as those held by Federal Reserve Chair Jerome Powell. During his semiannual monetary policy report to Congress in 2021, Powell expressed his belief that M2 and monetary aggregates no longer hold significant implications for economic growth, stating, “When you and I studied economics a million years ago, M2 and monetary aggregates seemed to have a relationship to economic growth. Right now… M2… does not really have important implications. It is something we have to unlearn, I guess.”

Federal Reserve Board chairman Jerome Powell speaks during an interview at the Renaissance Hotel in Washington, on Feb. 7, 2023. (Julia Nikhinson/Getty Images)

Meanwhile, many leading recession indicators have been flashing red again

The Conference Board Leading Economic Index (LEI), which evaluates credit, labour, and manufacturing, has a six-month average of negative 3.6%.

“While the rate of month-over-month declines in the LEI has moderated in recent months, the leading economic index still points to risk of recession in the U.S. economy,” said Justyna Zabinska-La Monica, the senior manager of business cycle indicators at the Conference Board, in a statement.

Since July 2022, the spread between the two-year and 10-year Treasury yields, which is closely monitored, has been inverted and is currently trading at around negative 60 basis points as of April 11. This spread is widely regarded as the most significant recession indicator, as it has accurately signalled almost all recessions since the Second World War.

The Fed’s preferred recession gauge – the three-month and 10-year yields – has also been inverted since the end of October 2022, trading at negative 167 basis points.

Normally, long-term bonds offer higher yields compared to short-term securities. However, in a scenario where the financial market foresees a weak economic outlook and a credit crunch in the banking system, this trend may reverse.

Furthermore, in March, the Institute for Supply Management’s Manufacturing Purchasing Managers’ Index (PMI) dropped to 46.3. Historically, almost every time this metric has fallen to such low levels, the U.S. economy has been in, or on the brink of, a recession. However, the manufacturing sector’s significance in today’s economy has decreased, accounting for only about 11% of the national GDP.

RBC Global Asset Management’s chief economist, Eric Lascelles, opines that the risk of a recession “has somewhat increased.”

“Whereas the risk of a U.S. recession over the coming year was at around 70% a few months ago, perhaps it is now up to an 80% chance,” he wrote in a note.

“A soft landing remains technically possible, but it is harder to achieve than before.”

Despite deteriorating economic metrics, Treasury Secretary Janet Yellen is confident the U.S. economy will avert a downturn.

The U.S. economy is obviously performing exceptionally well with continued solid job creation, inflation gradually moving down, robust consumer spending,” she said at a press conference on Tuesday.

So I’m not anticipating a downturn in the economy, although, of course, that remains a risk.

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