Shrinking Money Supply Undercuts “Soft Landing” Narrative

The better-than-expected non-farm payroll report for January along with the smaller interest rate hike delivered by the Federal Reserve at its February meeting increased optimism that the central bank can bring price inflation back to 2% without tanking the economy. But the shrinking money supply undercuts this soft landing narrative.

While Fed rate hikes and balance sheet reductions aren’t likely big enough to permanently take down inflation, they are shrinking the money supply and that generally means a recession is looming.

Money supply growth went negative for the first time in 28 years in November and fell again in December.

The money supply grew at an unprecedented rate during the pandemic. As Mises Institute senior editor Ryan McMaken pointed out in a recent article, between April 2020 and April 2021, money supply growth in the United States often climbed above 35% year over year. That was well above the “high” levels experienced from 2009 to 2013.

The last time year-over-year money supply growth went negative was in November 1994. Negative money supply growth continued for the next 15 months.

McMaken explains why this matters.

Money supply growth can often be a helpful measure of economic activity and an indicator of coming recessions. During periods of economic boom, money supply tends to grow quickly as commercial banks make more loans. Recessions, on the other hand, tend to be preceded by slowing rates of money supply growth. However, money supply growth tends to begin growing again before the onset of recession.”

McMaken points out that a declining money supply appears to be connected to yield-curve inversion, another recession signal.

For example, the 3s/10s yield spread often heads toward zero as money supply growth moves in the same direction. This was especially clear from 1999 through 2000, from 2004 to 2006, and during 2018 and 2019, and beginning in 2022. This is not surprising because trends in money supply growth have long appeared to be connected to the shape of the yield curve. As Bob Murphy notes in his book Understanding Money Mechanics, a sustained decline in TMS growth often reflects spikes in short-term yields, which can fuel a flattening or inverting yield curve.”

McMaken emphasized that it is not necessary for money supply growth to turn negative in order to trigger recession, defaults, and other economic disruptions.

With recent decades marked by the Greenspan put, financial repression, and other forms of easy money, the Federal Reserve has inflated a number of bubbles and zombie enterprises that now rely on nearly constant infusions of new money to stay afloat. For many of these bubble industries, all that is necessary for a crisis is a slowing in money supply growth, brought on by rising interest rates or a confidence crisis. 

Numerous indicators now point toward recession along with the falling money supply and the inverted yield curve. The Leading Economic Index is in recession territory. Real wages have fallen for twenty-one months. Homebuilder confidence fell every month of 2022. The Philadelphia Fed’s manufacturing index has been negative since September. Home price growth has been cut in half. The fact that the money supply is actually shrinking serves as just one more indicator that the so-called soft landing promised by the Federal Reserve is unlikely to ever be a reality. 

A SchiffGold analyst made a similar observation, saying, “The Fed may be confident in their rate hikes and the resiliency of the economy, but they are playing with serious fire. They have put the entire economy at risk for a major event as the liquidity has dried up extremely fast.”

The collapse in Money Supply has been sudden and epic. The risk this poses for the market at large cannot be understated. The Fed seems to be oblivious to the potential carnage it could cause. In 2018, it took interest rates of around 2.5% to bring the market to its knees. Rates are now almost double that. How much longer can things go on without a black swan event?”