The M2 Money Supply Contracted for the First Time Since the Great Depression, It Usually Signals a Big Move in Stocks

The U.S. economy hasn't fared well when M2 has notably declined in the past. There are only five occasions over the past 150 years where M2 fell by 2% or more on a year-over-year basis: 1878, 1893, 1921, 1931-1933. The previous four instances all resulted in deflationary depressions for the U.S. economy, along with a sizable increase in the unemployment rate, and now the fifth instance is ongoing.

Source: Venture Consulting

• In 1921, the M2 money supply fell by more than 2%, and the Dow Jones Industrial Average plummeted by 40% during the same period.

• During the Great Depression in 1931, M2 plummeted by over 12%, both the Dow Jones Industrial Average and the S&P 500 Index fell by more than 60% during the same period.

The reason behind the fall in M2 is straightforward. The Federal Reserve has been engaged in so-called quantitative tightening (QT), trimming its total assets to $7.68 trillion, as of Jan 3, 2024. down 14.3% from its record high in 2022. The Fed's reduction in its own balance sheet reduces the amount of money supply as the central bank is no longer reinvesting the proceeds from its matured bonds back into the system.

Another reason for the M2 shrinkage is the decline in bank deposits. Fed data show deposits contracted by 4.3% from a year ago, as of Dec 27, 2023 to $17.42 trillion. The growth rate of deposits has been in the negative territory since November 2022, although the pace of decline eased after tremors from the collapse of Silicon Valley Bank and Signature Bank in March subsided.

Major monetary aggregates like M2 money supply have been unreliable for forecasting the economy for several decades, Goldman Sachs economist Manuel Abecasis writes in the report. That's because the FOMC changed its policy framework to “Ample Reserve” Framework after the financial crisis.

Currently, the Committee implement monetary policy in a regime in which an ample supply of reserves ensures that control over the level of the federal funds rate and other short-term interest rates is exercised primarily through the setting of the Federal Reserve's administered rates, and in which active management of the supply of reserves is not required.

Under "Ample-Reserves" Framework, the demand for reserves held by banks and other depository institutions at the Fed increased dramatically, and banks are no longer constrained by reserve requirements. As a result, the volume of reserves held at the Fed has grown larger and more volatile, Abecasis writes.

Instead, the financial system uses liquidity proxy as a liquidity indicator, which includes the Fed assets, the Fed's Bank Term Funding Program (BTFP), the treasury general account (TGA), and the reverse-repo window, or ON RRP.

Liquidity remains abundant in the first quarter, with overnight reverse repurchase agreements still able to offset balance sheet reduction, but it's expected to start decreasing by the second quarter.

So, in today's implementation of monetary policy under the "ample reserves" framework, will the fifth time also bring shocks to the economy and in turn affect the stock market, as it did the previous four? Mooers, what are your thoughts on this?

Source: Barrons, Federal Reserve, Yahoo Finance, Goldman Sachs, Venture Consulting