Quarterly Review and Outlook Second Quarter 2023

Moving Further Down the Financial Cycle Curve

Monetary and fiscal indicators continued to tighten significantly in the second quarter pointing towards a material slowdown in the U.S. economy. Negative money growth, increasing fiscal deficit, rising real interest rates, and central banking guidance of higher short-term interest rates are creating a classic ‘credit crunch.’ This credit crunch comes as the economy progresses further down the current financial cycle, slowing growth and limiting upward pressures on inflation.

Credit Crunch at Hand

Money Supply and Velocity. Other deposit liabilities (ODL), in real terms, have turned negative for the latest 36 months, while the 12- and 24-month rates of contraction accelerated. The money mountain created in 2020-21, which supported spending and inflation, has been eliminated.

Historically, real ODL has increased at 3.2% per year. Although ODL velocity (ODL-V) rose in 2022, and in the first half of this year, the gain has been insufficient to offset the record contraction in real ODL over the last three years (Chart 1). As the quarterly data indicates, real ODL fell at a 1.2% annual rate over the past three years (the ending point for the blue line in this chart), compared to a 2.3% rate of increase in late 2019 just before the pandemic (‘C’ on Chart 1) and a 3.2% rate of increase since the early 1950s. Over the last three years, ODL-V averaged 1.7 (‘C’ on Chart 1), down from 1.9 when the pandemic hit and a 2.5 mean over the past seven decades.

Historically, it has been important to examine real ODL and ODL-V together as a complete unit. The Volcker Fed broke the inflation spiral that started in the 1960s as ODL-V remained stable (‘A’ on Chart 1). In the 1990s, real ODL went negative (‘B’ on Chart 1), but the economy continued to grow as ODL-V advanced sharply. From the 1950s to the early 1980s, fluctuations in ODL-V were so minor that the relationship between real ODL and nominal GDP was extremely tight. While ODL-V has increased over the past five quarters, the losses for 2020-21 have not been recovered, and ODL-V remains extremely depressed.

Real ODL and ODL Velocity.

Even a stable ODL-V will severely limit the Fed’s capabilities to stimulate economic growth. Monetary policy could be thwarted even more if V’s dominant determinants (the bank loan/deposit ratio and the marginal revenue product of debt) turn down.