US Fed might weigh rate cuts in a tighter liquidity environment
The US Federal Reserve is encountering mounting pressure to reduce the federal funds rate, owing to a decline in liquidity across the US financial system. The latest data reveals that the M2 monetary aggregate, a critical measure of money supply, suffered its first annual drop on record in December 2022, sinking by 1.2% year on year. This trend continued in the subsequent two months, with a sharper fall recorded. The latest data shows that in February 2023, M2 decreased by 2.2% year on year, propelled by a substantial 11.8% year-on-year drop in liquid deposits, which account for 62% of the total money supply. Commercial bank deposits in weekly frequency traditionally follow the same path as money supply. As they have been rapidly declining in March, M2 is expected to continue falling annually.
The recent decline in liquidity is driven by the uncertainty about the stability of the banking sector, combined with the appeal of higher-yielding investment opportunities, which prompted depositors to withdraw funds from banks. Further, the slowdown in the growth rate of both demand deposits and currency in circulation since the first half of 2022 has added to the liquidity concerns, although these two indicators have not declined yet.
In response to these liquidity challenges, the Federal Reserve may contemplate cutting interest rates earlier than anticipated to facilitate borrowing and enhance money supply. Such a move could relieve some of the pressure that banks are currently facing, making it easier for them to lend and ultimately boost economic activity. The next Federal Open Market Committee meeting is slated for May 3rd, and market consensus predicts that the monetary authority will refrain from taking any action regarding the fed funds target rate, which currently stands at 4.75-5%.
Further data and analysis on the US economy are available on the CEIC US Economy in a Snapshot – Q1 2023 Report.