by Ryan McMaken of the Mises Institute
Money supply growth fell again in August, falling to a 36-month low. August’s decline continues a strong downward trend from unprecedented highs experienced for much of the past two years. During the thirteen months between April 2020 and April 2021, the growth of the money supply in the United States often rose above 35 percent year-over-year, well above even the “high ” experienced between 2009 and 2013.
During August 2022, the year-over-year (YOY) growth of the money supply was 4.35 percent. This is lower than the July rate of 4.84 percent and lower than the August 2021 rate of 8.28 percent. The growth rate peaked in February 2021 at 23.12 percent.
Growth rates through most of 2020 and into April 2021 were well above what we had seen in previous cycles, with the 1970s being the only period that came close. Since then, however, we’ve seen a rapid decline from previous highs, and generally these rapid declines point to an economic contraction in the following months.
The money supply metric used here, the “true” or Rothbard-Salerno measure of money supply (TMS), is the metric developed by Murray Rothbard and Joseph Salerno, and is designed to provide a better measure of fluctuations in the money supply than M2. The Mises Institute now provides regular updates on this metric and its growth. This measure of money supply differs from M2 in that it includes Treasury deposits at the Fed (and excludes short-term deposits and retail money funds).
In recent months, M2 growth rates have followed a similar course to TMS growth rates. In August 2022, the growth rate of M2 was 4.077 percent. That’s down from July’s 5.25 percent growth rate. The August rate was also well below the August 2021 rate of 13.42 percent. M2 growth reached a new record high of 26.91 percent during February 2021.
Growth in the money supply can often be a useful measure of economic activity and an indicator of upcoming recessions. During periods of economic boom, the money supply tends to grow rapidly as commercial banks make more loans. Recessions, on the other hand, are usually preceded by a slowdown in the growth rates of the money supply. However, the growth of the money supply tends to grow again before the beginning of the recession.
Another recession indicator appears in the form of the gap between M2 and TMS. The TMS growth rate typically increases and becomes greater than the M2 growth rate in the early months of a recession. This happened in the early months of the 2001 and 2007-09 recessions. A similar pattern appeared before the 2020 recession.
Notably, this has happened again since May this year, as the M2 growth rate fell below the TMS growth rate for the first time since 2020. In other words way, when the difference between M2 and TMS goes from a positive number to a negative number. , this is a fairly reliable indicator that the economy has entered a recession. We can see this in this graph:
In the two “false alarms” of the last 30 years, the M2-TMS gap returned to positive territory quite quickly. However, when this gap enters firmly into negative territory, this is an indicator that the economy it’s already in recession. The gap has now been negative for 3 of the last 5 months. Interestingly, this indicator also seems to follow the inversion pattern of the yield curve. For example, the 2s/10s yield reversal was negative in all the same periods when the M2-TMS gap pointed to a recession. Also, the 2s/10s investment was very briefly negative in 1998, and almost turned negative in 2018.
This is not surprising because trends in the growth of the money supply have long appeared to be related to the shape of the yield curve. As Bob Murphy points out in his book Understanding of monetary mechanics, a sustained decline in TMS growth often reflects spikes in short-term yields, which can fuel a flattening or inverted yield curve. Murphy writes:
When the money supply is growing at a high rate, we are in a “boom” period and the yield curve is “normal,” meaning that the yield on long bonds is much higher than on short bonds. But when the banking system contracts and the growth of the money supply slows, then the yield curve flattens or even inverts. It’s no wonder that when banks “slam the brakes” on money creation, the economy soon goes into recession.
In other words, a significant drop in TMS growth levels often precedes a yield curve inversion, which points to an impending recession. Strong signs of recession can also be found elsewhere. GDP growth turned negative in both the first and second quarters of this year, and two consecutive quarters of negative growth almost always indicate a recession. National average home price growth in the US recently turned negative for the first time in a decade. Real weekly earnings have been negative for the past 17 consecutive months. Consumer debt rises as consumers borrow more money to make ends meet in this inflationary environment.
In other words, many other indicators point to exactly what we might expect: economic weakness and recession following a fall in money supply growth.
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Contact Ryan McMaken
Ryan McMaken (@ryanmcmaken) is a senior editor at the Mises Institute. Ryan holds a bachelor’s degree in economics and a master’s degree in public policy and international relations from the University of Colorado. He was a housing economist for the state of Colorado. He is the author of Commie Cowboys: The Bourgeoisie and the Nation-State in the Western Genre.
