RQA Economic Insights: April 2023 — Richmond Quantitative Advisors

RQA Indicator Spotlight: Money Supply

In this month’s economic data spotlight, we take a look at recent trends in the M2 Money Supply measure, called “M2”. M2 money supply is a key economic indicator that tracks the amount of money in circulation in the economy, including cash, checking deposits, savings deposits, and other time deposits. It is considered to be a broader measure of the money supply than M1, which only includes the most liquid forms of money such as cash and checking accounts. M2 money supply also includes assets that are highly liquid but not as readily available for spending, such as savings accounts and money market funds.

The Federal Reserve (Fed) closely monitors the M2 money supply as part of its efforts to manage the economy and control inflation. An increase in the M2 money supply can indicate that there is more money available for spending and investment, which can stimulate economic growth. On the other hand, if the money supply grows too quickly, it can lead to inflation, which is why the Fed seeks to manage the money supply carefully.

Overall, the M2 money supply is an important tool for economists and policymakers to understand the state of an economy and make decisions about monetary policy. By tracking changes in the money supply, policymakers can gauge the level of economic activity and adjust interest rates and other policies to promote stability and growth.

When plotting the annual change in the level of M2, certain trends can be identified related to where the economy may be tilting in terms of inflationary vs. deflationary pressures. The graphic below depicts the recent year-over-year growth trend profile.

*Source: Analysis by RQA. Data from FRED.*

The near-term trend in the M2 annual growth rate has gone negative since the start of 2023. Historically, it is seldom the case money supply levels show year-over-year contractions, as supply in the form of deposits are typically expanding on an annual timeframe. This contraction can be attributed to a reduction in risk taking and therefore credit creation within the M2 supply base. This reduction of money supply is part of the near-term target of the Fed, as they pull liquidity out of the economy to combat elevated inflation levels.

If we take a look at the longer term trend in the growth profile of M2 supply, overall growth is consistently positive around the 5-10% level annually. While some rapid declines in M2 growth preceded or coincided with economic contractions, it’s certainly not the case for all periods of decline or sluggish growth. What also sticks out within the data set is the large spike in M2 that occurred throughout the COVID-19 pandemic. This spike in money supply, with the benefit of some hindsight, can likely be attributed to the recent jump in U.S. inflation and is a key area of interest for Fed officials. Lastly, a contraction in the year-over-year supply of M2 is not a very common occurrence and points to the fairly large steps the Fed has been taking to combat inflationary pressures.

To conclude, M2 growth and its overall trend can help identify where the economy may be heading from an inflation vs. deflation standpoint. Given the unprecedented spike in M2 during the COVID period, having M2 money supply reverting back to trend is fairly intuitive and is likely somewhat healthy for long-term price stability - which is the ultimate goal of the Fed and U.S. Treasury. That being said, the pace of change and ultimate severity and duration of this M2 contraction will be key as it relates to knock-on effects to the overall economy looking forward - and if it goes too far for too long, it may cause more harm than good. As we move forward, we will be keeping an eye on these figures as they evolve with hopes in seeing more moderations in their rates of change and a stabilization back to more historic trend-like figures.

Economic Forecast Model

Checking on the RQA Economic Forecast Model for the month of April, the model measured at -0.23 (vs. March reading of -0.24). While the minor uptick is noted, the overall forecast remains below the zero bound, which suggests the broader economy is sputtering or on the verge of slowing. A shift into positive territory would indicate a more robust outlook for growth in the next few quarters.

*Source: Analysis by RQA. Data from U.S. Federal Reserve; Bureau of Labor Statistics; Norgate Premium Data; Institute for Supply Management*

The RQA Economic Forecast Model represents a consolidated composite of key economic leading indicators and market-based explanatory variables. The goal of this composite model is to present a holistic measure of primary U.S. economic growth drivers and their trends over time. (Additional detail on the model’s construction is provided here.)

Values above the zero-line are indicative of positive U.S. economic growth expectations in the near-term, and therefore, indicate economic strength and lesser chance of recessionary pressure. On the other hand, values below the zero-line represent the opposite - a more negative outlook and more elevated probabilities of the U.S. experiencing an economic contraction.

TAKING A CLOSER LOOK AT THE ECONOMIC DRIVERS

In the economic heatmap below, we are able to peak under the hood at a wide mix of underlying growth drivers in the U.S. economy. By reviewing this underlying data in more detail, we are better able to see how the underlying components of the U.S. economic growth picture are behaving through time. The indicators presented below have each proven to have predictive qualities in estimating the future direction of U.S. economic growth.

In reviewing the data reported through March, we continue to note the following:

U.S. labor data remains in moderately positive year-over-year trends, allowing the Fed to remain hawkish on inflation. Note, job openings data has started to show signs of softening;
U.S. commercial output figures continue to worsen, as evidenced in the latest data for industrial production, manufacturing, and new residential building permits;
Trends in income and consumption figures seem to be losing momentum, particularly as year-over-year sales growth in retail sales actually dipped into negative territory in March; and
Financial market readings continue to show warning signals, as yield curves remain inverted, intermediate-term equity market trends remain subdued, and corporate bond spreads remain relatively elevated.

MARKET REGIME DISCUSSION

As of late, the primary focal point of market participants has been the declining levels of U.S. inflation, as evidenced by interest rate markets starting to price in “back to normal” levels of CPI in the next 3-6 months - particularly given the latest inflation print coming in below 5%. That being said, markets today are now quickly moving their attention to the next major item: corporate earnings.

As earning season kicks off, investors are keeping a keen eye towards how hard the last 12 months of declining liquidity and rising interest rates have been on corporate earnings. As we witnessed disruption within the banking sector in the first quarter, understanding the knock-on effects to company fundamentals will help decide where we end up on the growth profile moving forward. For now, earnings appear to be somewhat soft, and therefore, in line with what broader economic conditions are suggesting - but we’ll see how that holds up over the next month, as more companies report their results.

Given the latest trends in inflation data and leading economic indicators, we believe we remain in an environment that’s still best characterized by uncomfortably-elevated inflation and below target growth (i.e., a modest stagflationary environment). That being said, many of the leading indicators and data points tracked by RQA’s economic assessment tools are somewhat mixed or right on the dividing line. While CPI and PCE inflation data points remain elevated, they are continuing to decline into more moderate territory. We would be cautious if these trends continue and economic fundamentals continue to lose momentum, as we could find ourselves entering in a deflationary bust environment (bottom left quadrant), which is more characteristic of the traditional economic recessions experienced in the U.S. since the 1980s.