America's Cash Crisis: the Shrinking Money Supply!

Hey everyone, welcome back to We're Talking Money, where we're breaking down complex financial topics so you can make better informed decisions with your money. I'm Phil Clark, and today we're going to dive into a topic that's getting a lot of attention lately: the shrinking money supply. What could this mean for investors like you in 2025?

Now, first things first, let's define what I mean by shrinking money supply. So money supply refers to the total amount of money that's available in a given economy. Today we're talking about the US, of course. It includes everything from cash to deposits and other liquid assets like stocks and bonds, for example. When the money supply shrinks, it means there's less money circulating through our economy. As you might imagine, this can have a big impact on inflation or interest rates and the overall economic growth of the country.

What happens when the money supply shrinks? Well, in simple terms, it's a little bit like taking the fuel out of the economy's gas tank. And when there's less money in circulation, spending drops, businesses may struggle to get credit, and people might hold off on making big purchases. This can have a dramatic effect on economic growth. It causes things to slow, and in some cases can even trigger a recession.

Our Federal Reserve affects our money supply with interest rates, for the most part. Moving rates higher, as they did just a few years ago, that takes money out of the system, because consumers and businesses generally borrow less when interest rates are higher. Hence, fewer dollars are in motion.

Let's zoom in on the US for a minute. Over the last two years, actually, we've seen a notable reduction in the US money supply, particularly in measures like M2. And M2 is what we use because it includes cash and checking deposits and any easily accessible savings accounts, stocks, bonds. Anything included in M1 supply is calculated in the M2 supply.

So we noticed this contraction that started back in 2022. Remember, inflation came at a roaring pace. In fact, it reached a 40-year high. Basically, that forced the Fed into action, and they raised rates like we really haven't seen in a long time, one of the most aggressive rate hikes in our history. This isn't something that happens every day. Historically, the US money supply, it's generally growing, especially during periods of economic expansion. The M2 money supply has been on a bit of a downward trajectory.

Our Federal Reserve, they actually began quantitative easing programs a long time ago, and that helped get us to where we are today. They had policies designed to increase money supply by a huge amount. That goes all the way back to 2008, during the global financial crisis. At that time, Federal chair Ben Bernanke:

The Federal Reserve will continue to use the tools at its disposal to improve market functioning and liquidity.

He was espousing the idea of printing our way out of some very, very major financial challenges. Those programs lasted until around 2020, so almost 12 years later we were still pumping tremendous amounts of money into the system. When the pandemic triggered even more massive increases in money supply to support the economy, the government said, why not? So much for growing ourselves out of all of this using quantitative easing. It didn't really work.

Now, you might be wondering, how many times has the US money supply shrunk since the Federal Reserve was created back in 1913? There have only been a few periods in our history where the money supply has significantly contracted. The most notable in the 1930s, one of the greatest severe economic downturns, that today we call the Great Depression. We didn't see another major contraction in our money supply until the early 1980s, and that happened to be under Federal Reserve chairman Paul Volcker.

This Administration today, here and now, declares unconditional war on poverty in America.

He's well known for his interest rate hikes to curb inflation. But since the 1980s, the money supply has generally grown.

Can a shrinking money supply cause a recession? Yes, it can. Shrinking money supply is not the only factor, but it definitely makes borrowing more expensive, both for the consumer and for businesses. That leads to reduced spending and investing, and depending on the velocity of a slowdown in economic activity, the results can be mild to as much as a severe recession. During both the Great Depression and the early 1980s, shrinking money supply, it was a key driver.

However, I think it's important to note that recessions, they are multifaceted events. High inflation, geopolitical instability, those things can contribute to economic slowdowns. If you look around the globe, we actually have a lot of those things at play right now. So with the Fed suggesting that fewer rate cuts are on the horizon, it looks like real rates will be higher for longer. That remains restrictive in terms of their policy. So unless the Fed can thread an incredibly small eye in the needle, I think it's likely that we're going to be seeing a challenging environment for stocks, bonds and even real estate in 2025.

Well, what about President Trump? He was reelected. He says he's going to save everything. Well, regardless of who is in the White House, implementing new policies will take time. In the meantime, here are a few tips on navigating what I believe is going to be a potentially volatile market in 2025.

So first, it's diversification. When money is tight, different sectors and asset classes, they usually respond in different ways. So consider having a good mix of stocks and bonds, commodities such as gold, and maybe even cash. In fact, I think cash is a pretty smart move. Bonds could suffer if interest rates stay high. Other assets like gold and Treasury Inflation-Protected Securities, or TIPS, they could do better in a tighter monetary environment.

Go for noncorrelated assets. This is my best advice. If you're investing in the stock market and any type of investable asset, they're generally correlated, and that means if the economy fails or goes down, all of those types of assets will generally repic in a similar fashion. Noncorrelated assets means that you have assets that are markedly different from other asset classes, and that means you're likely to be a little more stable or safer in your overall investment program.

Number two, be ready for volatility. In fact, expect it. If history is any guide, a shrinking money supply can lead to severe market swings. If you're a long-term investor, meaning you're looking at five, 10 or more years, try not to panic. But it is a good idea to check your programs, check your portfolio, and be sure that it still matches what you're trying to accomplish over the long term. Time is your friend when it comes to investing. But if you're closer to retirement, on the other hand, you might want to consider some safer options like cash or high quality bonds. Check with your financial advisor or your CPA to be sure you're not taking too much risk.

And number three, pay attention to the Federal Reserve. Pay attention to their rate decisions and any signals they give about the future direction of their monetary policy. Believe me, when they speak, it can move the markets.

So to sum it up, a shrinking money supply, we said, it can slow economic growth and potentially lead to a recession, mild to severe. Now, we're in a period of contraction, and it's something to keep an eye on as we move into the new year. I believe it's crucial to stay diversified, be prepared for volatility, and please stay on top of Federal Reserve moves. If you remember nothing else from today's video: markets are notoriously unforgiving during periods of money tightening phases, which we're in, and that means great volatility, and the likelihood of a recession increases.

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