The money supply contracted for the first time. What does stagnation mean.

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The Federal Reserve faces a very important decision in the coming weeks. Markets expect the central bank to raise interest rates by a quarter of a percentage point, marking a significant slowdown in the pace of history-making increases.

If the dial is implemented, it will be for good reason — the price increases look what they are work start. The annual pace of inflation slowed in December for six consecutive months and looks set to continue to slow.

There is another sign that the Fed’s rate hike is working: the amount of money in the economy shrank in December. Growth of M2—a measure of money supply in an economy that includes currencies in circulation, balances in retail money market funds, savings deposits, and more—has been slowing over the past two years after rising in 2020, but in December the numbers show a dip.

December’s money supply growth rate was negative 1.3% year-on-year, the lowest on record and representing the first ever decline in M2 based on all available data. The Fed started tracking the metric in 1959. November’s growth was already at 0.01%, well below the peak of 27% growth in February 2021.

The decline points to a cold economy and a strong path to higher rates, one that seems to be fueling fears of a recent recession. However, a strong economic downturn is not what the metric indicates. M2 is still 37% higher than it was before the pandemic despite going through one of the most severe slowdowns. In other words, the amount of liquidity in the system is still high, economists say, indicating the need for more efforts to normalize the economy.

Families still live on many of these [2020] deposits,” he says viral acharyaformer deputy governor of the Reserve Bank of India and current professor of economics at NYU Stern, referring to the stimulus checks that led to an increase in bank deposits in 2020.

This is not the only reason why M2 is rising – it is also rapidly declining. So, we can take a look at the Fed’s balance sheet actions. Quantitative easing, or bond buying, by the Federal Reserve during the pandemic helped boost the economy and the central bank’s balance sheet, pushing it nearly $9 trillion. Now, the Fed is shrinking its total assets through what’s called quantitative tightening, which is… reduce liquidity.

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The Fed’s total assets fell 5.3% on Jan. 18 since last year’s peak, yet the balance sheet remained more than double the $4.1 trillion in February 2020 before the start of the pandemic. That’s a lot of money, but the Fed doesn’t want to risk upsetting financial markets by going faster with tightening.

said Acharya, who works with three other economists published paper In August entitled Why shrinking central bank balance sheets is such a daunting task.

Ultimately, with M2 falling further, it should continue to help calm inflation as a decline in money reserves curbs demand and reduces “the ability to support bank loans and other forms of financing to households and businesses and financial market transactions,” said Nathan Sheets. Citi Global President. economic.

But investors shouldn’t assume that a decline in M2 will automatically signal an economic slowdown, writes Richard Farr of Merion Capital Group. Even if it matters, he said M2 “has to go down by at least another trillion dollars.”

That’s a long way to go.

Write to Karishma Vanjani at karishma.vanjani@dowjones.com