Macro Signposts | 29 May 2024

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Is the Supply of Money a Sign of U.S. Economic Stress?

U.S. economic strength has underpinned markets this year, a trend many experts see continuing: The consensus in Bloomberg's latest survey of professional economic forecasters foresees 2024 full-year GDP growth of roughly 2.5% – two percentage points higher than the consensus a year ago. Also, the survey's average estimated likelihood of U.S. recession has dropped to 30% (from 65% a year ago).

We've recently laid out arguments for why U.S. growth has been strong (see our Cyclical Outlook), and why – despite some cooling – growth may remain solid (see last week's Macro Signposts). Nevertheless, there are still economic indicators that aren't so rosy, and in fact are at levels that could be a harbinger of impending recession. For example, a key indicator is real money supply growth: It's been negative for the better part of the past year – historically, a trend associated with looming weakness.

Keep an eye on the money supply
Monetarism, the school of economic thought closely linked to Milton Friedman, argues that changes in the money supply have a direct and predictable effect on nominal GDP. The quantity theory of money, which is central to monetarism, relates nominal GDP to the product of money supply and money velocity (how frequently money changes hands through economic transactions). And only the government (through managing bank reserve levels) and banks (through lending) can create money.

Federal Reserve Chairman Paul Volcker applied the quantity theory of money to bring inflation down in the late 1970s and early 1980s by establishing explicit reserve targets that limited bank lending and growth in the money supply. However, the ensuing period of elevated interest rate volatility contributed to the Fed's move away from strict reserve targeting in 1982 in favor of the more flexible approach of managing the level of the fed funds interest rate. And indeed, charting real money supply growth against real GDP (see Figure 1) suggests a relatively tight leading relationship until the early 1990s, when the relationship became less stable.

Figure 1: U.S. real money supply growth versus real GDP growth since 1972

Chart

Source: U.S. Bureau of Economic Analysis, Federal Reserve, Haver Analytics, and PIMCO calculations as of April 2024. M2 is an estimate of total money supply encompassing physical cash and deposits in checking accounts, savings accounts, and short-term savings vehicles.

Since 2020, we've seen wild swings in U.S. money supply growth as policymakers made large fiscal and monetary injections (via a large increase in government debt, much of which was purchased by the Fed) to help offset the economic drag of the pandemic. In line with the theory, the growth in money supply coincided with elevated inflation and a surge in real GDP growth.

However, after an initial spike due to pandemic-related policy supports, the money supply began to contract. At its lowest point in December 2022, money supply fell at an annual pace of 10.7%, and coincided with a sharp deceleration in annual real GDP growth from 15% to 2%. Since early 2023, both the money supply and real GDP growth have rebounded. However, there's a sizable gap between them: As shown in the chart, as of April 2024, real money supply growth declined by 2.7% (annualized), while estimated real GDP growth grew by over 3% (annualized).

What explains this currently large gap between money supply growth and real GDP growth? The quantity theory of money suggests that a strong increase in the velocity of money can create such a gap (remember, according to the theory, the product of real money supply growth and the real velocity of money equals real GDP growth). Essentially, the pandemic appears to have revived the speed at which money changes hands: It had been low for over a decade following the global financial crisis (GFC).

Indeed, post-GFC, low money velocity was problematic for the Fed, which was aiming to establish higher inflation through its large-scale asset purchase programs, which supplied the system with reserves and a larger base of money. During that decade, the decrease in money velocity offset the rise in the monetary base, reducing the effectiveness of the asset purchase programs in translating money supply growth into higher real growth and inflation.

Higher velocity – for how long?
Now we are seeing the opposite phenomenon. Money supply growth has been contracting, but velocity has accelerated, supporting solid real GDP growth. But how long can elevated velocity persist?

While money velocity, like productivity, is notoriously difficult to forecast, we see several reasons why money velocity could remain relatively high.

First, consider another historical analogue: In the 1990s, money supply growth was chronically below real GDP growth (i.e., money velocity was elevated). That decade was characterized by capital deepening (i.e., an increase in the ratio of capital to labor) due to the implementation of new technologies, including the internet and personal computers, which contributed to the productivity boom of the late 1990s. We see potential parallels to the nascent AI-related capex boom, which will require significant investment in infrastructure, including energy infrastructure, to power data centers.

Second, unlike after the GFC, when elevated business and consumer bankruptcies and delinquencies led to dramatically tighter credit conditions, consumer and business balance sheets are stronger coming out of the pandemic than they were going in – thanks to significant government stimulus that raised real wealth. More recently, U.S. industrial policies that focus on investing in infrastructure and that help mobilize private capital through tax incentives are also supporting activity. We've argued these factors could continue to support the U.S. economy at least over our cyclical horizon.

Finally, the boom in private credit markets may also be keeping money velocity at elevated speeds. Although banks have tightened credit conditions as the Fed raised rates – bank credit growth has been roughly flat over the last year – private credit markets have grown, shifting the makeup of corporate debt markets. According to the Federal Reserve Financial Accounts of the U.S. ("Z.1" accounts), corporate borrowers are relying more heavily on the private markets, shifting from public high yield bond markets to the securitized loan market and other private debt structures, while banks are shifting their lending toward private credit intermediaries (e.g., business development companies or BDCs) and away from more capital-intensive and expensive direct corporate loans.

This boom in private lending may be blunting the extent to which tighter financial conditions slow the economy. The pass-through of changes in market interest rates to interest payments is faster in private credit markets, which are dominated by variable rate structures, where most companies pay SOFR (the Secured Overnight Financing Rate) plus a spread. However, many companies that haven't secured financing in public markets or through direct bank loans (due to company size or riskiness) have secured financing in the private markets. Consistent with this, IMF data suggest that private credit conditions haven't responded to tighter bank lending standards, while the interest rate spread over SOFR that companies pay has compressed dramatically.

Solid capital inflows, plus a large supply of investor "dry powder," have supported net new lending in private credit markets. Companies have been able to sustain higher interest payments because, according to aggregate data on non-corporate business sector wealth, most midsize businesses still have high liquid and financial asset balances from pandemic-related transfers, and nominal growth has remained strong. Furthermore, consumer- and residential-housing-related lending also look solid, outside of the subprime categories, as over a decade of underbuilding relative to population trends has kept housing inventories low.

Key takeaways
Elevated money velocity is supporting real GDP growth in the U.S., despite contracting money supply. As a result, we do not think this is a harbinger of a looming recession. Eventually, this high-velocity economic party could end. However, generally strong private sector balance sheets, including those of consumers, and the elevated value of housing assets after a decade of underbuilding, could support solid U.S. growth and elevated money velocity somewhat further. Coupled with potential for accelerated capital deepening related to AI implementation, it's possible U.S. GDP growth may stay supported despite flat to somewhat contractionary money supply growth.

Nevertheless, taking a step back, U.S. real growth appears to be slowing from an elevated 3% level to a still very solid 2% pace in the first half of 2024. And as the economy normalizes, we are seeing more divergence across different areas of the economy, as well as more mixed messages from different economic indicators.

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