A Look at M2 Growth and Inflation in Recent Years

In a May 2023 Economic Synopses essay, Senior Economic Policy Advisor Christopher Neely discussed the unusual behavior of the year-over-year growth rate of M2 starting in February 2020.

M2 is a broad measure of the money supply, which Neely explained includes currency and various relatively liquid bank and money market mutual fund deposits. “M2 grew at record rates during the COVID-19 pandemic from February 2020 through 2022 but has declined at record rates since late 2022,” he wrote. He also examined the behavior of inflation over this period, noting that inflation followed M2 growth on the way up and had been following it coming back down.

M2 Growth and Inflation

Neely looked at monetary aggregates and inflation through the lens of monetarism, which was a prominent school of thought several decades ago before largely falling out of favor. He noted that the classic claim of monetarism is that growth in some monetary aggregate drives inflation, likely with a “long and variable” lag of between six months and two years.

“Recent inflation behavior has been consistent with a lagged effect of M2 on personal consumption expenditures (PCE) inflation,” Neely wrote. For instance, he cited the rise of PCE inflation beginning in February 2021, which coincided with the peak M2 growth rate of 26.9% and was a year after M2 growth began to soar. In addition, he noted that PCE inflation peaked in June 2022, more than a year after M2 growth peaked. (See the FRED graph below.)

M2 Growth and Monetary Policy

Neely then looked at a figure showing M2 growth, monetary base growth and the target range for the federal funds rate. The monetary base is “the sum of currency in circulation and reserve balances (deposits held by banks and other depository institutions in their accounts at the Federal Reserve),” as the Federal Reserve Board of Governors explains on a frequently asked questions page.

Neely noted that patterns in the figure suggested the monetary policy decisions that the Federal Open Market Committee had taken to bring inflation back down had helped reduce M2 growth to negative levels.

In particular, he cited the FOMC’s November 2021 announcement that it would begin tapering its asset purchases, as well as the end of those asset purchases and the start of the increases in the federal funds rate target range in March 2022.

“During the first half of 2022, growth in the FOMC-influenced monetary base fell to negative levels and thereby tended to reduce broader aggregates, such as M2,” Neely wrote.

NOTE: The purple dashed line denotes November 2021.

Neely concluded: “Macroeconomic theories are approximations, at best, because complex relationships between unpredictable people make the global economy a constantly evolving place. Still, advocates of links between monetary aggregates and prices will surely study this episode closely in years to come.”