According to Nomura, the collapse in the US money supply is an "elephant in the room" for the markets

(Bloomberg) — A strategist at Nomura Holdings Inc. warns investors are missing a crucial clue as they grapple with the trajectory of US inflation and the Federal Reserve’s response.

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The growth rate of M2, which measures cash in circulation plus dollars in bank and money market accounts, rose during the pandemic as Federal Reserve emergency funding flowed through the economy.

Now it’s falling fast, shrinking 2.4% year-on-year in February after falling into the red in December for the first time since at least 1960, according to Fed data compiled by Bloomberg.

Vincenzo Inguscio, a London-based volatility strategist at Nomura, says the change is key to understanding the outlook for markets. He believes this is both a sign that inflation will return to “very low” levels and that the Fed should pause efforts to reduce its balance sheet.

“It seems like the elephant in the room” for the markets, he said in an interview. “M2 has never fallen so fast. People need to keep an eye on money supply dynamics when they fluctuate so much.”

The link between monetary growth and inflation has long been a hotly debated topic. It played a key role in predicting Fed policy in the 1970s and 1980s, but gradually declined in importance as its ability to explain the US economy seemed to diminish.

Some argue that the precipitous annual contraction in the money supply was inevitable after rising so rapidly. The amount of cash sloshing around also remains high on a historical basis.

Historic contraction in M2 gives Fed cover for pause: Karl Smith

However, a January paper by staffers at the Bank for International Settlements found that looking at monetary growth would have helped improve post-pandemic inflation forecasts. James Bullard, President of the St. Louis Fed, said in January that the dramatic slowdown in M2 growth bodes well for disinflation.

Running on fumes

Nomura’s Inguscio fears the world’s biggest economy is already on steam, with the recent collapse of three US banks a warning sign of underlying tensions.

The central bank has hiked rates by a total of 475 basis points since last March.

“If you drive a car without fuel, eventually it just won’t work,” Inguscio said.

“The fall in the money supply shows how quickly the Fed hit the brakes,” he added. “The recent increase in the Fed’s balance sheet is probably evidence that it probably did too much too quickly.”