The Rise and Fall of M2 from St. Louis Fed

 During the pandemic, M2, a broad measure of money supply, experienced an unusual surge, increasing by more than 25%. This was a significant leap compared to the 5-6% increase observed in the aftermath of the financial crisis. Intriguingly, even during the financial crisis, when the monetary base expanded by more than 25%, M2 did not exhibit a corresponding increase. However, in an unprecedented development, M2 began to decline at a negative rate following the pandemic.

Inflation rates, as indicated by Personal Consumption Expenditures (PCE), appeared to mirror the trajectory of M2. The PCE began to rise approximately a year after the M2 surge. Given that M2 started to decline negatively in December 2022, it is projected that PCE will follow a similar path and potentially decrease by the end of 2023.

The article from the Federal Reserve Bank of St. Louis discusses the rise and fall of M2, a broad measure of the money supply that includes currency and various types of bank and money market mutual fund deposits that are relatively liquid.

Key points from the article include:

1. The year-over-year growth rate of M2 has behaved unusually since February 2020. M2 grew at record rates during the COVID-19 pandemic from February 2020 through 2022 but has declined at record rates since late 2022. The 26.9% rate of year-over-year growth in February 2021 exceeds the rates of growth during either the quantitative easing programs of 2008-15 or the inflations of the 1970s and 1980s. At the same time, the current negative rates of growth are also unprecedented.

2. The Monetarist School of Economics, associated with Milton Friedman and the University of Chicago, argued for the importance of monetary aggregates in economic activity. However, Monetarism fell out of favor because it was nearly impossible to find strong and consistent relations between monetary aggregates and variables of interest, such as prices and output.

3. The article suggests that recent inflation behavior has been consistent with a lagged effect of M2 on personal consumption expenditures (PCE) inflation. PCE inflation began to rise in February 2021, at the peak of M2 growth rates and a year after M2 growth began soaring in February 2020.

4. Monetary policy decisions taken to curtail inflation helped reduce M2 growth to negative levels. In November 2021, the FOMC announced that it would begin to "taper" its asset purchases, which finally ended in March 2022, the same month in which the FOMC began raising the federal funds target.

5. The article notes that huge growth in the monetary base in 2008-15 did not spark unusual growth in M2 or inflation during that period. This occurred because banks essentially swapped bonds for reserves held at the Federal Reserve.

6. The article concludes by stating that macroeconomic theories are approximations, at best, because complex relationships between unpredictable people make the global economy a constantly evolving place. However, advocates of links between monetary aggregates and prices will surely study this episode closely in years to come.

Source: https://research.stlouisfed.org/publications/economic-synopses/2023/05/25/the-rise-and-fall-of-m2