US M2 weakness not signalling economic relapse
Monday, November 9, 2009 at 12:23PM
Simon Ward

The monetary approach to economics argues that "excess"money – the difference between the supply of money and the demand to hold it – is a key influence on spending and financial investment decisions. Assuming that the (unobservable) demand for money is stable, shifts in "excess" money will reflect changes in money supply growth.

Money demand, however, has been unstable in 2008 and 2009. The financial crisis led to an increase in liquidity preference as investors scrambled to sell "risky" assets. More recently, desired cash levels have fallen in response to low interest rates and reviving markets. Strong inflows to US and UK equity and bond mutual funds are one sign of reduced money demand.

The chart shows six-month growth in US broad money M2 together with a six-month running total of flows into or out of US funds, expressed as a percentage of M2. A strong inverse relationship is apparent since the start of 2008. The recent monetary slowdown and pick-up in fund inflows is the mirror-image of late 2008, when a surge in M2 accompanied record outflows.

The implication is that buoyant M2 growth in late 2008 overstated support for the economy and markets from "excess" money because the demand for cash was temporarily elevated by a flight from "risky" assets. Conversely, recent M2 weakness may not imply "deficient" money because liquidity preference has fallen back.

Rather than M2 itself, the sum of money growth and mutual fund flows – the third line in the chart – may provide a better guide to shifts in "excess" money. This indicator has performed well recently: it weakened sharply from mid 2008, warning of a deepening recession, but recovered late last year and in early 2009, foreshadowing the revival in markets and the economy.

Some monetarist economists claim that recent M2 stagnation signals renewed economic weakness in 2010. The indicator incorporating mutual fund flows, however, remains at a healthy level, suggesting monetary underpinnings for an ongoing recovery. This message is supported by more upbeat narrow money trends – see previous post.

Article originally appeared on Money Moves Markets (https://moneymovesmarkets.com/).
See website for complete article licensing information.