“Inflation is always and everywhere a monetary phenomenon.” - Milton Friedman
These words from Uncle Milty, as those of us who studied Economics refer to him, came to me as I read the news that the Money Supply1 (M2) shrank on a year-over-year basis for the first time in at least 60 years. The chart nearby shows M2’s percent change over one year going back to 1960.
Inflation can be summed up by the phrase, “too many dollars chasing too few goods.” If the money supply grows very quickly, without a corresponding increase in economic output, we tend to see inflation. Over the 3-year period ending earlier this year, the money supply grew by $5 trillion, or almost 37%, so it’s not difficult to see why we see inflation running hotter than historically.
If we compare M2 over the past 30 or so years to a simple trend line in the nearby chart, we see that in 2020 the Federal Reserve's (Fed’s) easy money policy drove M2 significantly above trend. One could make the argument that there are still “too many dollars” in the economy, which would support Chairman Powell’s assertion that the Fed, even if it pauses its rate increases, will need to keep rates higher for longer. 
We recently highlighted several potential fiscal policy pressures (“Quantitative Teasing” - April 4, 2023) that may keep inflation higher than the market would like, which would further argue against the Fed easing monetary policy any time soon, potentially leading to further declines in M2.
Portfolio Implications
A shrinking money supply, while disinflationary in nature, should lead to the cost of capital likely remaining higher, as rates stay higher for longer and lending standards tighten meaningfully.
A higher cost of capital generally favors lower duration equities and fixed income, which argues for a defensive posture in portfolios.
At SS&C ALPS Advisors, we continue to take a “Bird in the Hand” approach to asset allocation, favoring shorter duration quality assets that generate near term cash flows and dividends over longer duration assets.
Important Disclosures & Definitions
1 M2 consists of M1 plus (1) small-denomination time deposits (time deposits in amounts of less than $100,000) less IRA and Keogh balances at depository institutions; and (2) balances in retail MMFs less IRA and Keogh balances at MMFs. Seasonally adjusted M2 is constructed by summing savings deposits (before May 2020), small-denomination time deposits, and retail MMFs, each seasonally adjusted separately, and adding this result to seasonally adjusted M1.
M1 consists of (1) currency outside the US Treasury, Federal Reserve Banks, and the vaults of depository institutions; (2) demand deposits at commercial banks (excluding those amounts held by depository institutions, the US government, and foreign banks and official institutions) less cash items in the process of collection and Federal Reserve float; and (3) other liquid deposits, consisting of OCDs and savings deposits (including money market deposit accounts). Seasonally adjusted M1 is constructed by summing currency, demand deposits and OCDs (before May 2020) or other liquid deposits (beginning May 2020), each seasonally adjusted separately.
Performance data quoted represents past performance. Past performance is no guarantee of future results; current performance may be higher or lower than performance quoted.
AAI000251 09/30/2024
