In the United States, the M2 measure of monetary growth fell 1.3% year on year in December

In the United States, the M2 measure of monetary growth fell 1.3% year on year in December, a record low.Unsurprisingly, those with monetarist sympathies argue that this heralds a recession and collapsing inflation.

Even St. Louis Fed President Bullard argued that the slowing of monetary growth bodes well for lower inflation.But Mr. Steve Barrow, Head of Standard Bank G10 Strategy believes that this is wrong; just like claims that the post-pandemic surge in monetary growth led to the inflation that we are seeing today.

"We’ve argued many times that, most often, history is a good guide to the past. In this case, it means that even if monetary growth was some sort of pre-inflation (or disinflation) warning in the past, which it was not, today’s alarming fall is nothing to get excited about. The difference today is quantitative easing and quantitative tightening", said Mr. Steve Barrow.

For just as the surge in US M2 monetary growth, to an annual peak of 26.9% in February 2021 reflected the pandemic pump-priming by the Fed, so the subsequent fall reflects the Fed’s reversal as it seeks to cut its bond holdings by around USD1tr per year. The reduction in these Fed assets has its counterpart on the liability side of the balance sheet, notably in the reserves that banks hold with the Federal Reserve banks.

And just as the Fed’s assets have fallen by around half a trillion dollars since the peak last March, so commercial banks’ reserves have fallen to around USD3tr from a peak of close to USD4.25tr at the end of 2021. The monetarists might argue that this does not really matter; it’s all money whether the reduction is coming from bank reserves or somewhere else in the M2 definition, like deposits.

However, Mr. Steve Barrow thinks it is important, and we can see this if we look not at money supply but at money demand, or more specifically, the demand for loans. For while M2 growth might be languishing at a -1.3% annual rate at the moment, banks’ commercial and household loans are still flying high at a 12% annual rate right now. This shows that loan demand is still robust, which could well prove to be a sign of robust economic growth and potential inflationary pressure, not deflationary pressure.

For banks, the hefty level of reserves they hold with the central banks may reflect the fact that they still feel rather flush and hence are more willing to accommodate this loan demand than they might have been in the past. Data from the Fed’s loan officer survey, which gauges banks’ willingness to extend credit, does show that lending conditions have tightened, but it is not on a par with what we’ve seen in prior recession or pre-recession periods. This suggests to us that the "bite" from higher Fed policy rates as far as consumers and firms are concerned might not quite be as sharp as the Fed needs to bring inflation back to target.

And then there is another argument. It is that if monetary growth has a relationship with anything it is most likely nominal GDP, meaning inflation plus real growth. If monetary growth expands and demand in the economy increases, the amount of inflation will largely depend on whether this increased demand can be met easily – and cheaply – through easily-expandable supply chains.

In the pre-Covid period, this seemed perfectly possible and hence robust monetary growth did not lift inflation (it lifted asset prices instead because the supply of assets is less flexible – or inelastic to use an economic term). But in the post-Covid period, the supply of extra goods and services has become inelastic due to things like clogged supply chains and labour market tightness. This suggests to us that even slower monetary growth now could still be consistent with higher inflation than we’ve experienced in the past. "We don’t see it as a particular comfort to the disinflationary process that money supply growth is slowing rapidly in the US and elsewhere", said Mr. Steve Barrow.