The U.S. money supply is shrinking for the first time since 1949, as savings deposits decline and the Federal Reserve shrinks its $8 trillion balance sheet. The drop stems mostly from changes in Fed policy and rising interest rates, but it says little about the prospects for inflation or the likelihood of recession, according to Goldman Sachs Research.
Major monetary aggregates like M2 money supply — which includes things like physical currency and coins as well as small time deposits and retail money market funds — have been unreliable for forecasting the economy for several decades, Goldman Sachs economist Manuel Abecasis writes in the team’s report. That’s because forces that have little effect on economic activity have caused large changes in the demand for reserves, cash, and deposits.
The demand for reserves held by banks and other depository institutions at the Fed increased dramatically when the central bank changed its policy framework after the financial crisis: policymakers in Washington now control the funds rate by paying interest on reserves, 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.
Financial innovation has also changed things. Credit and debit cards have reduced the amount of cash that’s needed to make transactions. It’s also cheaper and easier for households to buy financial assets like bonds, which means a smaller share of savings ends up in deposits and is included in the figures for monetary aggregates.
Changes in interest rates influence the form of savings — savings accounts versus bonds and stocks, for example — that people are likely to use. Mortgage refinancing, which is also sensitive to interest rates, causes swings in the monetary aggregates because the mortgage loan principal is held in custodial deposit accounts until refinancings are completed.
Financial regulations can also have an impact. For example, a change in the way the Federal Deposit Insurance Corporation levied its deposit insurance premium in 2011 artificially increased the number of foreign deposits that were classified as domestic, which spurred a temporary increase in the monetary aggregates.
The demand for U.S. currency from abroad, meanwhile, has further distorted the link between monetary aggregates and economic outcomes. Foreign demand for greenbacks has risen steadily as a share of nominal (not inflation-adjusted) GDP since the early 1990s, and foreign currency demand doesn’t imply that there will be more transactions in the U.S., according to Goldman Sachs Research.
Businesses may also borrow money and hold it in savings when decision makers are more uncertain about what’s ahead. Abecasis points out that business currency holdings and loans rose sharply at the height of the pandemic because companies feared they might need funds to pay their bills if the economy shut down for a long time, and not because they intended to undertake new investments.
So what is driving the recent decline in the money supply? And does it matter?
M2 has declined by roughly $700 billion since the hiking cycle began, as a roughly $2.4 trillion drop in savings deposits has been offset by increases in the other components of the money supply. So far, the decline is in line with the historical relationship between deposits and interest rates, suggesting that higher interest rates likely already capture the information relevant for borrowing and economic activity provided by the monetary aggregates, Abecasis writes.
The Fed has reduced its balance sheet holdings by around $800 billion, which has put pressure on savings deposits. That’s because the Treasuries and mortgage-backed securities the Fed used to hold now have to be financed with bank deposits or other kinds of money. Banks have mainly responded to the drop in deposits by raising new funding through things like large time deposits, by selling financial assets, and by slower lending, according to Goldman Sachs Research.
However, tighter credit is only one of several ways banks have responded to the decline in deposits, and the decline in the monetary aggregates over the last year doesn’t translate dollar-for-dollar to a decline in lending and is not a good way of estimating the impact on lending and investment, Abecasis writes.
Our economists say a better way to estimate the impact of tighter monetary policy and financial conditions on the economy is by using market prices and interest rates rather than quantities such as M2. They say there’s a more robust statistical link between changes in Goldman Sachs Research’s broad financial conditions index and GDP growth, which for example captures the effect of higher interest rates on homebuilding or the effect of lower asset prices on consumer spending.
Market prices directly influence trade-offs between consumption and savings, and they are immune to the changes in how monetary policy is implemented and other ad-hoc definitional changes that can cause big changes in monetary aggregates that have little relevance for economic activity. Goldman Sachs Research finds that this approach also has a stronger predictive track record, and it avoids the common mistake of assuming a fixed mechanical link between reserves and lending or deposits and spending.
Using that framework, our economists expect the tightening in financial conditions and bank lending standards to cause a drag of 0.3 percentage points on GDP in the second half of 2023, a decline from the 1.2 percentage-point drag in 2022 when the financial conditions index tightened sharply as the Fed turned hawkish.
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