Nomura Says US Money Supply Plunge Is ‘Elephant in the Room’ for Markets

(Bloomberg) — A Nomura Holdings Inc. strategist is warning that investors are overlooking a crucial clue as they grapple with the path of US inflation and the Federal Reserve’s response.

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The growth rate of M2, which measures cash in circulation plus dollars in bank and money-market accounts, spiked during the pandemic as emergency funding from the US central bank sluiced through the economy.

Now it’s falling fast, contracting 2.4% year-on-year in February after dipping into the red in December for the first time since at least 1960, according to Fed data compiled by Bloomberg.

Vincenzo Inguscio, a London-based volatility strategist at Nomura, says the change is key to understanding the outlook for markets. He reckons it’s both a sign that inflation will return to “very low” levels and that the Fed should pause efforts to reduce its balance sheet.

“It seems like the elephant in the room” for markets, he said in an interview. “M2 has never fallen this fast. People need to keep an eye on the money supply dynamic when it swings so much.”

The link between money growth and inflation has long been the subject of fierce debate. It played a key role in predicting Fed policy in the 1970s and 1980s, but gradually faded in importance as its ability to explain the US economy appeared to diminish.

Some argue the precipitous year-on-year contraction in money supply was inevitable after such a fast increase. The amount of cash sloshing around also remains elevated on a historic basis.

Historic Contraction in M2 Gives Fed Cover to Pause: Karl Smith

But a January paper by staff at the Bank for International Settlements noted that looking at money growth would have helped improve inflation forecasting in the wake of the pandemic. St. Louis Fed President James Bullard said in January that the dramatic decline in M2 growth “bodes well for disinflation.”

Running on Fumes

Nomura’s Inguscio worries that the world’s biggest economy is already running on fumes, with the recent failure of three US banks a warning sign of underlying strains.

The central bank has hiked rates by a cumulative 475 basis points since last March.

“If you run a car with no fuel, at some point it will simply stop working,” Inguscio said.

“The drop in money supply shows how fast the Fed has been pushing on the brakes,” he added. “The recent spike in the Fed’s balance sheet is probably evidence of the fact that they have done probably too much, too quickly.”