The M2 money supply in the USA: What it is and what changes in its volume mean.

The M2 money supply is a good indicator of trends in any economy: changes in its volume can predict inflation. Recently, the volume of M2 decreased for the first time since 1959.

We explain what this means, compare M2 to similar indicators, and explain why more comprehensive indicators are sometimes not so useful.

What has happened?

In February’s closing, the Federal Reserve determined that the money supply in December 2022 equaled 21.207 trillion dollars, reflecting a 0.67% decline from November 2022. Looking at the yearly statistics, the M2 quantity dropped by 0.58% from December 2021 to December 2022. Additionally, comparing January 2023 to January 2022 shows a 1.72% reduction in the M2 volume.

What does the M2 money supply show?

M2 is an indicator of the amount of money in the economy. It can be said that this is the most representative indicator of monetary liquidity: how much available money do businesses and consumers have in cash and, accordingly, how much they can spend.

M2 includes cash, traveler’s checks, savings accounts, deposits, time deposits, liquid securities, and money market funds.

The calculation of M2 is carried out by the US central bank (Fed) and is done once a month.

There are also other measures of the money supply: M1, M3, and M4. They also measure the amount of money in the economy, but M1 only includes cash and demand deposits. In other words, M1 includes less money than M2.

M3 is a more comprehensive metric. It includes all the money that is accounted for in M2, as well as deposits of large corporations and their liquid instruments, such as short-term debt obligations.

M4 is the most comprehensive indicator, including everything in M3 plus less liquid instruments, such as deposits and debt obligations with a term of 5 years.

Gold is not included in any of these metrics, as it is no longer considered the world’s unified currency standard. This is strange: gold occupies a very important position in ensuring the stability of a state’s currency precisely because it is considered a liquid instrument.

While M2 is not the most comprehensive metric, economists are closely monitoring it.

M2 is more comprehensive than M1 on the one hand, and more flexible on the other. If a company transfers its money from a money fund to its own account in the bank, the total volume of M1 money supply will increase, since money funds are not included in M1, so the nominal amount of money will increase.

In the case of M2, the total volume of the money supply will not change in the same operation, because M2 includes money funds. It is important that M2 changes in accordance with the spending of the majority of the population, whereas M3 and M4 include financial instruments that do not change so quickly.

It is important to understand that about 2/3 of the US GDP is generated by domestic demand, so M2, which shows the state of consumer finances – money on hand, deposits – allows us to track changes in the American economy more promptly. Moreover, M2 is calculated once a month, while M3 is calculated once a quarter. M1 is also calculated once a month, and M4 is not calculated by the US Federal Reserve – this indicator is calculated in England and some other countries.

What do changes in the volume of M2 signify?

Changes in the M2 volume indicate trends in the American economy.

If the M2 mass increases, it can serve as a signal that consumers will soon start spending the excess, thereby contributing to economic growth, as companies will begin to expand their production.

However, an increase in the M2 volume does not necessarily mean economic growth. Often, the M2 mass increases during periods of economic crisis because the US authorities usually lower interest rates and begin to stimulate economic growth in the country through direct injections – providing financial assistance to both businesses and citizens.

Thus, changes in the M2 volume indicate trends in the US economy.

If the M2 mass increases, it can serve as a signal that consumers will soon start spending the excess, thereby promoting economic growth, as businesses will start expanding their production.

However, an increase in the M2 volume does not necessarily mean economic growth. Often, the M2 mass increases during economic crises because US authorities typically lower rates and begin stimulating economic growth in the country through direct injections of monetary assistance to both businesses and citizens.

For example, the M2 mass increased significantly during the 2009-2011 crisis period and even more during the pandemic years: rates were lowered, and money flowed into the economy. The Federal Reserve System (FRS) bought bonds from financial institutions in huge quantities, and this provided banks with liquidity, which they lent to businesses and consumers at low rates. This was called a quantitative easing policy.

On the chart we provided, the increase in M2 during the pandemic period looks particularly “convex” because the government directly transferred money to citizens and businesses in large volumes during the quarantine period.

When rates rise, people start spending less, and banks begin transferring money to illiquid instruments such as long-term deposits and bonds, reducing the available money supply to the economy.

A decrease in the mass may signal that soon consumers – and subsequently businesses – in the US will start reducing their spending. In this case, a decrease in inflation and possibly a recession can be expected.

Currently, the decrease in M2 indicates that the FRS’s work to increase rates is bearing fruit, and processes are occurring that logically lead the US population to reduce their spending.

From the FRS’s perspective, the situation in the US can be characterized as follows: too much money and too few goods and services, which fuels inflation. Therefore, the FRS raises rates – so that money becomes more expensive for both consumers and businesses, reducing spending and lowering inflation. Recently, the FRS again raised the rate by 0.25% – to the limits of 4.75-5% – and is ready to raise it even more to combat inflation.

As of February 2023, inflation in the United States is quite high – 6%. However, this is significantly lower than it was in June 2022, when inflation was 9.1%. But such a decrease was the result of extremely aggressive rate hikes by the Federal Reserve: since June, they have increased by more than three times.

The decrease in the M2 money supply may lead the leadership of the Federal Reserve to the idea that it is not necessary to raise rates so aggressively. In this case, the slowdown in the US economy may occur more smoothly than it could have been.

For stocks, a slowdown in the pace of rate hikes will also be good news: loans will not become as expensive.