U.S money supply exploded during the pandemic as the government doled out trillions of dollars in stimulus. Those payments helped keep the economy afloat during a difficult time, but many economists believe they also contributed to the fierce inflation that followed. In any case, the Federal Reserve responded by tightening credit conditions at a velocity not seen since the early 1980s, and U.S. money supply is now falling at a historic rate.
Esteemed economist Steve Hanke sees that as a big problem. He recently said, "The money supply is falling like a stone, and is currently contracting at a minus 3.7% annual rate, something we have not seen since 1938." He believes the situation will culminate in a recession during the first half of 2024. But that opinion runs contrary to what the Fed is saying.
Here's what investors should know.
How money supply is measured
When policymakers and other economic experts talk about money supply, they are discussing the total amount of circulating currency. Money supply is dissected and measured in a few different ways, but M1 and M2 are two of the more common metrics.
The M1 money supply is the most narrow. It includes circulating currency and cash kept in checking accounts. The M2 money supply is slightly less narrow. It includes M1 plus cash kept in savings accounts, money market funds, and certificates of deposit issued for less than $100,000.
The chart below shows the year-over-year change in M2 money supply dating back to 1960. The point in time when the trend line drops below zero (i.e., December 2022) marks the point when M2 money supply started to contract. In other words, total M2 was smaller in December 2022 than it was in December 2021.
US M2 Money Supply YoY data by YCharts
Why money supply matters
Hanke, a professor of applied economics at Johns Hopkins University, is a proponent of monetarism, a macroeconomic theory built around the idea that surges in money supply will cause surges in inflation. So he has been ringing the recession alarm for several months, ever since U.S. money supply whipsawed from unprecedented growth during the pandemic to sharp contraction amid aggressive rate hikes from the Federal Reserve.
In October 2022, Hanke told Fortune that significant inflation has never occurred without a dramatic increase in money supply. He blamed Fed policymakers for flooding the economy with cash during the pandemic, and he blamed the Fed again for overtightening to combat inflation. He also said that policymakers are "steering the economy toward one whopper of a recession."
The Fed disagrees. Its stance is that, while money supply has shown a correlation with economic variables like inflation and gross domestic product (GDP) in the past, those correlations have become unpredictable in recent years. Indeed, after Fed policymakers forecasted a recession in March, Fed Chair Jerome Powell walked that statement back in July, saying central bank economists no longer expect a downturn.
Current economic data seems to justify the Fed's point of view. Despite a decline in money supply, GDP increased at an annualized rate of 2.1% in the second quarter, an acceleration from 2% growth in the first quarter, and early projections show a more substantial acceleration to 3.5% growth in the third quarter.
So here's the question: Is Hanke or the Fed correct?
What investors should do with a possible recession on the horizon
Arguments made by Hanke and the Fed both have merit. On one hand, rapid growth in pandemic-era money supply was indisputably followed by the worst inflation in 40 years. It also seems logical that a rapid decline in money supply could reduce spending and drag the economy into a recession. On the other hand, GDP is growing at a healthy pace, and the unemployment rate is well below average.
So who is right? I wish I could tell you. But the truth is that patient investors have little to fear in either scenario. The U.S. economy has suffered three recessions in the last three decades, but the S&P 500 (SNPINDEX: ^GSPC) still returned a total of 1,630% during that time period, or roughly 10% annually. There is no reason to expect a different outcome over the next three decades.
Also noteworthy, the S&P 500 typically bottoms before economic activity bottoms, and stocks typically rebound before economic activity rebounds. In other words, market timing strategies will almost certainly fail. So investors are left with just one prudent course of action: Come rain or shine, stay invested and keep buying high-quality stocks.
