2 years ago

197

TOPICS AND TIMESTAMPS:
Inflation 0:00
M2 and Savings 1:49
What To Watch 4:33

The recent decline in broad money, also known as M2, should not necessarily be interpreted as an indication of incoming deflation. Instead, a closer examination of the components of broad money reveals that inflationary forces are still present.

Factors such as underweights in real assets, low long-term yields, and inverted yield curves suggest that the market is underestimating the long-term effects of persistent and entrenched inflation. Despite posting its first year-on-year decline in 60 years, it's important to note that M2 and its narrow-money counterpart M1 are often misunderstood in terms of their impact on the economy.

It is often mistaken that there is a direct correlation between changes in M2 and changes in inflation. However, just because two variables appear to be related, it does not mean there is a causal relationship. In reality, a third variable is likely influencing both M2 and inflation.

Upon closer examination, it becomes clear that there is not a strong relationship between M2 and inflation. It's important to note that M2 is counter-cyclical, which is a fundamental aspect that is often overlooked.

The largest component of M2 is savings deposits. Unlike demand deposits, which are current-account money and deposit money created for loans, money tends to be moved into savings deposits during times of risk-aversion or perceived slowing growth. Conversely, money is often moved out of savings deposits and into current accounts during periods of increased economic activity and optimism. The increase in savings deposits in late 2020 was an early indication that strong inflationary pressures were on the horizon in 2021.

In the past, there was a clear distinction between M1, which primarily consisted of demand deposits, and M2, which was mostly composed of savings deposits. However, in May 2020, the Federal Reserve decided to include savings deposits in the Other Liquid Deposits component of M1, following an amendment to the Fed's Regulation D, making savings and demand deposits more interchangeable.

Despite this change, we can still track savings deposit data. In this chart, which shows savings deposit data reversed and pushed forward by 12 months, it is clear that it leads the inflation trend as measured by the Cleveland Fed's Median CPI. The fact that growth in savings deposits has not yet begun to rise suggests that underlying inflationary forces have not yet subsided.

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.

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