By Ryan McMaken
Money supply growth fell again in May, falling to its lowest level in three months. May’s decline continues a downward trend from all-time highs recorded for most of the past two years. During the thirteen months between April 2020 and April In 2021, money supply growth in the United States often exceeded 35% year-over-year, well above even the “high” levels recorded from 2009 to 2013. While money supply growth monetary policy returns to “normal”, this indicates recessionary pressures in the near future.
In May 2022, the year-on-year (YOY) growth of money supply was 6.97%. That’s down from the April rate of 7.25% and down from the May 2021 rate of 15.40%. The growth rate peaked in February 2021 at 23.12%.
Growth rates for most of 2020, and through April 2021, were far higher than anything we’ve seen in previous cycles, with the 1970s being the only period that came close.
The measure of money supply used here – the “true” or Rothbard-Salerno money supply measure (TMS) – is the measure developed by Murray Rothbard and Joseph Salerno, and is designed to provide a better measure of money supply fluctuations than M2. This measure of money supply differs from M2 in that it includes Treasury deposits with the Fed (and excludes short-term deposits and retail money funds).
Unlike TMS, M2 growth rates have continued to decline over the past five months, with the growth rate in May falling to 6.60%. That’s down from April’s growth rate of 8.21%. The May rate was also well down from the May 2021 rate of 14.30%. M2 growth peaked at a new high of 26.91% in February 2021.
Money supply growth can often be a useful measure of economic activity and an indicator of future recessions. During periods of economic boom, the money supply tends to grow rapidly as commercial banks extend more loans. Recessions, on the other hand, tend to be preceded by a slowdown in money supply growth rates. However, money supply growth tends to pick up again before the onset of the recession.
Another indicator of the recession appears in the form of the gap between M2 and TMS. The growth rate of TMS generally climbs and becomes higher than the growth rate of M2 in the first months of a recession. This happened during the first months of the 2001 recession and the 2007-2009 recession. A similar trend emerged before the 2020 recession.
This notably happened again in May this year, when the growth rate of M2 fell below the growth rate of TMS for the first time since 2020. In other words, when the difference between M2 and TMS goes from a positive number to a negative number, it’s a pretty reliable indicator that the economy has entered a recession. We can see it in this graph:
During the two “false alarms” of the last 30 years, the M2-TMS gap returned fairly quickly to positive territory. However, when this spread moves firmly into negative territory, it is an indicator that the economy is already in recession. Interestingly, this indicator also seems to follow the yield curve inversion pattern. For example, the 2s/10s yield reversal turned negative in all the same periods when the M2-TMS spread indicated a recession. Additionally, the 2s/10s reversal was very briefly negative in 1998, then almost turned negative in 2018.
This is not surprising, as trends in money supply growth have long seemed linked to the shape of the yield curve. As Bob Murphy notes in his book Understand monetary mechanics, a sustained decline in TMS growth often reflects short-term yield spikes, which can fuel a flattening or inversion of the yield curve. Murphy writing:
When the money supply is growing at a high rate, we are in a “boom” period and the yield curve is “normal”, which means that the yield on long bonds is much higher than that on short bonds. But when the banking system contracts and money supply growth slows, the yield curve flattens or even inverts. It is not surprising that when the banks “brake the brakes” with money creation, the economy quickly goes into recession.
In other words, a significant decline in TMS growth levels often precedes an inversion of the yield curve, which itself indicates an impending recession. In effect, we can see this right now in mid June 2022. The Atlanta Fed’s gross domestic product was also announced. predicts further economic contraction in second quarterwhich would formalize a recession according to the definition adopted by the National Bureau of Economic Research.
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