The contraction in the M2 money supply, which had provided some relief from inflationary pressures, appears to have ended. In March, M2 increased by $92 billion, marking the largest monthly increase since 2021. Although this equates to an annualized rate of 5.5%, signaling a moderate expansion, it is a step away from the contractionary trend that had helped slow inflation. The positive trend in recent months is also evident in the 3-month and 6-month changes in M2, which are the highest since early 2022.
The increase in M2 is raising concerns that inflation may remain elevated for longer than anticipated. If M2 continues to expand, the potential for further inflationary pressures increases. This is particularly relevant given that M2 rose at an annualized rate of 1.24% over Q4 in 2023, while GDP is expected to rise by 2.5% annualized. If velocity remains stable, this would suggest that the potential for further inflation remains.
However, economists note that there is no evidence of a permanent impairment in velocity, and M2 velocity is expected to rise by about 1% if GDP forecasts hold true. This would be the smallest quarterly change in several years, bringing velocity close to the 2020Q1 dropping-off point. However, higher interest rates typically imply higher money velocity, indicating that we may be approaching a turning point.
The resurgence of M2 is timely, as markets and the economy were beginning to show signs of tightness. While reducing the money supply is necessary to bring inflation under control, it can also have negative consequences for economic growth. An economy requires a certain amount of money to function effectively, and the recent contraction in M2 had started to cause some concerns.
In the long run, price stability requires that the growth in M2 approximately matches the growth in GDP. For instance, if we want 2% inflation, then M2 should grow about 2% faster than GDP. However, velocity changes introduce complexities, and the steady decline in velocity since 1997 is the primary reason inflation remained tame despite excessive money growth during that period. With the long decline in interest rates ending, the long-term downtrend in velocity is likely over, suggesting that money supply growth needs to be brought under control to prevent sustained inflation.
Getting money supply growth back to the neighborhood of 4% should allow for 2-2.5% growth with restrained inflation over time. However, achieving this balance will be challenging, and the path forward may not be as smooth as it appears on paper. Nevertheless, there is reason for cautious optimism as the Federal Reserve continues to reduce its balance sheet, which should eventually bring inflation below the sticky zone and back towards the target range.
