Money Supply and Inflation

Money Supply and Inflation

The Federal Reserve recently cut interest rates by 0.25% in its ongoing effort to keep the economy growing while managing inflation. This follows the previous rate cut of 0.5% in September, and there’s talk of another possible cut in December.

The Federal Reserve only has so many ways it can impact the economy, most notably interest rates and buying and selling government securities, or “open market operations”. When the Fed BUYS securities, it is injecting money into the banking system. When the Fed SELLS securities, it is withdrawing money from the banking system. One measure of money supply that the Fed keeps a close eye on is M2. Included in M2 is cash, savings accounts, and other stores of money with maturity dates of less than two years such as CDs and money market funds.

“when money supply increases faster than production, you get inflation”

Why does money supply matter and what does it have to do with inflation? There has been a lot of research done, but the idea is when money supply increases faster than production, you get inflation. Go figure. There are a lot of other factors, but we are just talking about money supply today. What happened to M2 during the COVID-19 pandemic? A TON of money was injected into the economy. An eye-watering 17.6% increase in just four months between February 2020 and June 2020. . . and how have prices been?

M2 grew quickly due to government stimulus and other policies aimed at keeping the economy afloat. This led to concerns about inflation. Now as M2 growth has slowed, inflation rates have started to cool. This pattern suggests that when the money supply is controlled, inflation pressures can ease up.

When inflation is coming down, it doesn’t mean prices are coming down. It just means the rate of increase is getting back to normal. Yes our purchasing power is down, but this is another reason to have a plan and the confidence to stay invested through the turmoil. Anything can happen in the market and it’s a very dangerous thing to say “it’s going to be different this time” or “it’s going to happen just like before”.

One thing we do believe is that being a long term investor carries less risk than doing nothing.