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What is M2 Money Supply?

June 10, 2024June 22nd, 2024No Comments

The M2 money supply is a method for assessing the amount of money in circulation within an economy. It is considered a broad measure because it includes various types of funds, not just those most liquid and readily available for everyday transactions, as M1 does. For example, M2 in the United States encompasses:

  1. M1 Money Supply: This category includes physical currency, demand deposits, traveler’s checks, and other checkable deposits. Essentially, it represents the money that is readily accessible for everyday transactions.
  2. Savings Deposits: These are funds held in savings accounts. While not used for daily transactions, they can be quickly transferred to checking accounts when needed, making them a versatile component of the money supply.
  3. Small-Denomination Time Deposits: These include fixed-term deposits, such as certificates of deposit (CDs), that are under $100,000. They offer a way to earn interest on savings while being relatively liquid.
  4. Retail Money Market Mutual Funds: These accounts represent investments in money market mutual funds available to individual investors. They provide a way to earn returns while maintaining access to funds.

By considering these components, M2 provides a comprehensive view of the money available in an economy, reflecting both liquidity and savings.

Importance of M2 Money Supply

M2 is used for economic analysis as it provides a comprehensive overview of the money supply available in an economy for spending and investment. It reflects the liquidity available to consumers and businesses, influencing economic activity, inflation, and ultimately the exchange rate of a currency.

M2 Money Supply and Economic Policy

The central bank of an economy controls the money supply through injections and withdrawals. Typically, central banks introduce money into the economy by purchasing treasury bonds. This process provides the central government with liquidity, which ultimately gets spent in the economy. Additionally, by entering the treasury market as a buyer, the central bank suppresses the yields on treasuries. This action has a ripple effect, making borrowing cheaper and further increasing the money supply. The treasuries purchased by the central bank go onto its balance sheet, a process known as quantitative easing or “QE”.

When the central bank buys treasuries and suppresses yields, investors tend to seek higher returns elsewhere. As a result, they move their investments from the bond market to riskier assets, such as stocks and real estate. This behavior further boosts the money supply, as it encourages investment and spending in other sectors of the economy.

In special scenarios and major shock events, the central bank may also buy high-grade corporate bonds in addition to treasuries to inject liquidity into the economy more quickly.

To reduce the money supply, the central bank generally does the opposite. Instead of buying treasuries, it sells them from its balance sheet, which has the inverse effect. As yields on treasuries increase, borrowing becomes more expensive, and liquidity is withdrawn from the economy. This process is known as quantitative tightening or “QT”.

Higher yields attract investors back to the bond market, as the risk-free rate becomes more appealing. Consequently, investors may pull their money out of riskier assets, reducing overall investment in those areas and further tightening the money supply.

 

M2 as a Leading Indicator for Economic Trends

The M2 money supply can serve as a valuable leading indicator for predicting central bank actions and economic growth. By analysing the positive or negative percentage growth of M2 at each data release, you can gain insights into potential future trends in inflation, deflation, and monetary policy adjustments.

Using M2 Data Effectively

Data Collection: For example, in the US, the St. Louis Fed releases M2 data monthly. Collect this data regularly to monitor changes.

Histogram Analysis: Plot the rolling 3 month average M2 growth data into a histogram to observe whether the growth is normally or abnormally distributed. Consider the mean and standard deviations to understand the distribution pattern.

Ongoing Monitoring: Continuously check the M2 data releases. When standard deviation events occur, you can potentially predict future inflation or deflation and anticipate central bank policy adjustments.

Overall, central banks aim for the money supply to grow steadily over time to meet their inflation targets. However, if you assess an economy’s M2 and observe a persistent slow decline over time, this could indicate that rate cuts may be on the horison. Conversely, if the money supply is abnormally high over time, it could indicate that rate increases might be forthcoming.

By systematically analysing M2 data, understanding normal and extreme movements, and considering historical contexts, you can develop informed strategies for currency hedging.

Extreme Values and Economic Crises

Positive Outliers: Significant increases in M2 often correlate with economic crises, where the central bank injects large amounts of money to counteract deflationary threats. Historical examples include periods following the 2008 financial crisis and the more recent COVID-19 pandemic.

During the COVID-19 pandemic, the Federal Reserve implemented an aggressive quantitative easing (QE) program to stabilise the economy. From March 2020 to December 2020, the Fed increased its holdings of Treasury securities and mortgage-backed securities by approximately $3 trillion. This massive injection of liquidity significantly boosted the M2 money supply, reflecting the Fed’s efforts to counteract the economic downturn caused by the pandemic.

Negative Outliers: Significant decreases in M2 indicate strong deflationary pressures, often preceding periods of aggressive monetary easing by the Fed.

Example of Money Supply and Currency Exchange Rate Movements

Economy A has a rapidly increasing money supply. Over the past year, the central bank of Economy A has implemented aggressive monetary policies, increasing the M2 money supply by 15% annually to stimulate economic growth. This significant increase in money supply has led to rising inflationary pressures, eroding the purchasing power of Economy A’s currency, the A-dollar.

Economy B, on the other hand, has a rapidly decreasing money supply. In response to concerns about overheating and high inflation, the central bank of Economy B has tightened monetary policies, reducing the M2 money supply by 10% annually. This contraction in money supply has led to deflationary pressures, increasing the purchasing power of Economy B’s currency, the B-dollar.

As a result of these contrasting monetary policies, the value of the B-dollar is expected to increase relative to the A-dollar. Businesses and individuals anticipate that the tightening in Economy B will lead to higher interest rates and stronger economic fundamentals, making the B-dollar more attractive. Conversely, the loose monetary policy in Economy A is likely to continue weakening the A-dollar due to ongoing inflation.

Historical Context and Practical Applications

During economic crises, large injections into the M2 money supply are common. Understanding these patterns helps predict the central bank’s next moves and their potential impact on the exchange rate. For instance, during the 2008 financial crisis, many central banks, including those in advanced economies, significantly increased their money supply to counteract deflationary pressures and stimulate economic activity. Recognising such trends allows you to anticipate future monetary policy actions and their effects on currency values.

Rolling Analysis

By analysing M2 on a rolling 3 month basis, you can identify trends and make informed predictions about future economic conditions and currency movements. For example, if Economy A’s M2 money supply consistently shows large increases over several rolling periods, it signals ongoing inflationary pressures, guiding you to expect a weaker A-dollar. Conversely, consistent decreases in Economy B’s M2 money supply indicate deflationary trends, suggesting a stronger B-dollar.

Conclusion

The M2 money supply is a key economic indicator that helps predict inflationary and deflationary trends, guiding you in your decisions regarding currency exchange rates. By systematically analysing M2 data, understanding normal and extreme movements, and considering historical contexts, you can develop informed strategies for currency hedging. This comprehensive and objective approach ensures better anticipation of monetary policy changes and their impact on the currency’s value.

While M2 is a valuable tool, it should only be used as one tool among multiple economic indicators, such as Manufacturing PMIs and balance of payments, to form a well-rounded analysis.

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