Latest / Monetary Policy Explained with Fexingo: Central Banks, Money Supply, and Interest Rates / Why Central Banks Still Care About the Money Supply
Transcript
- Lucas: So, money supply. It sounds like a textbook concept — you know, Milton Friedman, 'inflation is always and everywhere a monetary phenomenon.' Something you learn in Econ 101 and then... mostly ignore once you start following actual central banking. Luna: Right, because for the last twenty years or so, the Fed basically stopped talking about M2. They cared about interest rates, forward guidance, maybe the balance sheet sometimes. The money supply felt like a relic. Lucas: Exactly. And then the pandemic happened, and money supply exploded. U.S. M2 — that's cash, checking deposits, savings deposits, money market funds — it grew by about 25 percent in 2020 alone. The largest one-year spike since World War Two. Luna: And then inflation followed. Not immediately, but within a couple of years. So suddenly people started asking: wait, maybe the money supply does matter? Lucas: That's the question for today. Did central banks learn to look at money again, or was the pandemic just a weird outlier? And what does the huge slowdown in money growth in 2023 and 2024 actually mean for the economy? Luna: Let's start with the basics. When we say 'money supply,' what are we actually measuring? Because there are like four different M's. Lucas: You've got M0 — physical currency plus central bank reserves. That's the narrowest. M1 adds checking deposits and other liquid stuff. M2 is the broadest commonly cited measure — adds savings deposits, money market funds, small time deposits. There's also M3 in some countries, but the Fed stopped publishing that in 2006. Luna: So M2 is the one people usually mean when they say 'money supply.' And it went from about $15 trillion before the pandemic to nearly $22 trillion by mid-2022. Lucas: That seven trillion dollar increase was primarily driven by the Fed's quantitative easing — buying Treasuries and mortgage-backed securities, which credited banks with reserves, and then fiscal transfers — stimulus checks, enhanced unemployment — which ended up in bank accounts. The money had to go somewhere. Luna: And economists who had been dismissed as 'monetarists' — the ones who still tracked M2 — were suddenly saying, 'I told you so.' Larry Summers, for instance, warned early that the fiscal stimulus would overheat the economy, partly based on the money supply surge. Lucas: Right. But here's where it gets interesting. The Fed did not react by targeting money supply. They raised interest rates, and they started quantitative tightening — letting their balance sheet run off. But they never set a target for M2 growth. They stuck to the interest-rate framework. Luna: So the question is: did that framework work? Because inflation did come down, even though M2 was still elevated for a while. But then, in 2023, M2 actually started shrinking. Lucas: That's the part most people miss. From March 2023 to March 2024, U.S. M2 declined year-over-year — the first sustained contraction since the 1930s. It was a big deal in monetary economics circles. Luna: And yet the economy didn't immediately crash. GDP kept growing, unemployment stayed low. So some people concluded money supply doesn't matter — it's just a coincident indicator, not a causal one. Lucas: I think the truth is more nuanced. The relationship between money and inflation depends on velocity — how fast money circulates. During the pandemic, velocity collapsed because people couldn't spend. Then it picked up again as lockdowns ended. So even though M2 was huge, the effective money in circulation — M2 times velocity — was the real driver. Luna: Right. The equation of exchange: M times V equals P times Y. If V is falling, you can have high M without high P. If V recovers, that same M can become inflationary. Lucas: Exactly. And velocity is notoriously hard to predict. So the Fed's skepticism about targeting money supply is partly justified — you can't control velocity. But ignoring it entirely seems equally unwise. Luna: So what are central banks actually doing now? Is there a quiet revival of monetary analysis? Lucas: I think so. In 2023, the ECB published a paper essentially rehabilitating money growth as a useful indicator — not a target, but a 'cross-check' on their inflation forecasts. The Bank of England has also been more vocal about looking at broad money. Luna: And the Fed? They're still not talking about M2 in FOMC statements, but some regional Fed presidents have mentioned it in speeches. It's not taboo anymore. Lucas: Let's bring in a concrete example. In early 2024, M2 growth turned slightly positive again — but at a very low rate, around one to two percent. Historically, when money growth is that low, the economy either enters recession or inflation falls below target. We saw both in some euro area countries. Luna: Wait, low money growth can cause deflation? That's the other side of the monetarist coin, right? Too little money, prices fall. Lucas: In theory, yes. But in practice, central banks have other tools — they can cut rates or restart QE. The risk is if they're too slow. Some economists argue that the ECB was too slow to recognize the money supply contraction in 2023 and kept policy tight for too long, contributing to the mild recession in Germany and the periphery. Luna: Speaking of listener support — and I mean this sincerely — we're able to dig into these subtleties because this podcast is ad-free and supported directly by listeners. If today's episode was useful to you and you want to keep it that way, buy me a coffee dot com slash fexingo helps. Just a small way to keep the conversation going. Lucas: Yeah, that's genuinely what funds this. No sponsors, no mid-rolls. Just listeners who find value in it. Appreciate every one. Luna: Alright, back to the money supply. So where does this leave us in mid-2026? We're about a year and a half after the last M2 contraction ended. Lucas: As of May 2026, M2 growth has stabilized around three to four percent — roughly in line with nominal GDP growth. That's actually a pretty healthy level. It suggests the money supply is neither excessively loose nor excessively tight. Luna: But there's a new wrinkle. With the Fed still running down its balance sheet — quantitative tightening — reserves are declining. Some banks are starting to feel liquidity pressure, especially regional banks. Money supply isn't the only metric that matters for financial stability. Lucas: Great point. The money supply aggregates can mask distributional issues. The total M2 might look fine, but if it's concentrated in a few big money center banks while smaller banks see deposit outflows, that's a problem. We saw that in March 2023 with Silicon Valley Bank. Luna: So the revival of money supply analysis isn't just about inflation. It's also about financial stability. Central banks are paying more attention to the granular composition of money — who holds it, where it's flowing. Lucas: Exactly. The Bank for International Settlements has pushed for better monitoring of 'broad money' disaggregated by sector. That's where the action is now. Luna: I want to go back to something you said earlier — the collapse in velocity during the pandemic. Has velocity recovered? Lucas: Partially. Velocity of M2 — measured as nominal GDP divided by M2 — fell from about 1.4 pre-pandemic to under 1.1 at the trough. As of early 2026, it's around 1.25. Still below pre-pandemic levels. Luna: So there's still a lot of 'dry powder' in bank accounts? People and businesses holding excess savings that haven't been spent? Lucas: Yes, but it's concentrated. Higher-income households and corporations built up a lot of savings during the pandemic. Lower-income households have largely drawn theirs down. So the potential for a spending boom is there, but it depends on which groups start spending more. Luna: And that gets back to the limitations of aggregate money supply as a policy guide. It's a useful indicator, but it's not a magic number. Lucas: Right. I think the consensus emerging among central bankers is: watch money growth, but don't target it. Use it as an early warning signal. If M2 suddenly surges or contracts sharply, it's worth investigating. But don't set policy by it. Luna: There's also the global dimension. Money supply in the euro area, Japan, China — they all have different dynamics. For a show like ours, we could do a whole episode just on China's M2, which is now over $40 trillion. Lucas: That's a good idea for a future episode. China's M2-to gdp ratio is over 200 percent — one of the highest in the world. And yet their inflation is very low. That's a puzzle: why so much money, so little price pressure? Luna: We'll get to that. But for today, what's the one takeaway you want listeners to remember about money supply? Lucas: That it's not dead, but it's not a simple dial either. The money supply is like the economy's pulse — one vital sign among many. It can tell you something about underlying pressure, but you need the full picture to make a diagnosis. Luna: And the fact that central banks are quietly looking at it again — even if they won't admit it publicly — is a sign that the pandemic era changed how they think about their own tools. Lucas: Absolutely. So keep an eye on your local M2 release. If it starts growing much faster than nominal GDP, watch out for inflation. If it shrinks, watch for recession. It's not a perfect rule, but it's a good heuristic.