Authored by Simon White, Bloomberg macro strategist,
The first ever contraction in broad money should not be taken as a sign deflation is around the corner. On the contrary, a closer look broad money’s components shows inflationary forces are alive and well.
Underweights in real assets, low long-term yields and inverted yield curves show that the market continues to underestimate the long-term impact from persistent and entrenched inflation.
Broad money, or M2, just posted its first year-on-year decline in its 60-year history. But M2, and its narrow-money counterpart M1, are misunderstood in their impact on the economy.
Rises and falls in M2 are naively assumed to lead to rises and falls in inflation. But two variables that look correlated don’t have to have a causative relationship, and the connection is in fact explained by a third variable.
M2 and inflation may look like they go up and down at similar times, but a closer inspection shows there is no strong relationship. The fundamental issue with M2 that is frequently not appreciated is that it is counter-cyclical.
The biggest constituent of M2 is savings deposits.
Unlike demand deposits, which is current-account money and deposit money created for loans, money tends to be moved into savings deposits when there is risk-aversion, or a perception of slowing growth.
Vice-versa: money is often moved out of savings deposits and into current accounts when animal spirits are frothing. The rise in savings deposits in late 2020 was one of the first signs that a strong inflationary impulse in the US was coming in 2021.
There used to be a clear division between M1, which was mainly demand deposits, and M2, which was mainly savings deposits, until May 2020 when the Fed decided that savings deposits would be swept into the Other Liquid Deposits component of M1. (This was due to an amendment to the Fed’s Regulation D which made savings and demand deposits more fungible.)
Nevertheless, we can reconstruct the savings-deposit data.
In the chart below it is reversed and pushed forward by 12 months, and we can see it clearly leads the inflation trend, as gauged by the Cleveland Fed’s Median CPI.
Growth in savings deposits has not started to rise yet, showing that underlying inflationary forces have not abated.
Headline inflation is likely to continue to fall due the lagged impact of commodity-price falls and base effects, but the contraction in M2 is not giving any signals that the inflationary regime is coming to an end.