Asset Allocator Insights: The Macro Series, Part 2- Tracking M1: From Stability to Turbulence
Over the past 25 years, the Eurozone has witnessed significant economic shifts, crises, and policy changes that have profoundly impacted its financial landscape. Understanding the dynamics of money supply is crucial to grasping how economies function and how inflationary pressures build up.This blog explores the evolution of the money supply in the Eurozone from 1998 to 2024 and its varied impact on inflation across different economic cycless.
I- Overview of the Money Supply
The money supply refers to the total amount of liquid assets available in an economy at a given time. It is generally divided into several categories based on the liquidity of the assets, with M1 being one of the most important indicators. M1 includes the most liquid forms of money, such as currency in circulation (bills and coins) and demand deposits (checking accounts). These assets are directly accessible for daily transactions and serve as a key indicator of immediate purchasing power within an economy.
Changes in M1 are often used to assess the immediate purchasing power in an economy, and they can provide insights into potential shifts in economic activity and inflation. In this blog, we will focus on the evolution of M1 in the Eurozone from 1998 to 2024, examining how fluctuations in this component of the money supply have influenced inflation over time. By analyzing key periods of economic stability, crises, and policy responses, we will explore the complex and sometimes delayed relationship between monetary expansion and inflationary pressures.
Figure 1: Evolution of the Composition of the Monetary Base
Since mid-2008, the monetary base has increased sevenfold. However, with CiC (currency in circulation) and M1 growing more slowly, most of the new money supplied by the ECB has accumulated as deposits by private banks at the ECB. This excess liquidity in the euro area now exceeds three trillion euros.
Figure 2: The Post-2008 Shift: M0's Decoupling from Other Monetary Aggregates
Until 2008, all monetary aggregates moved largely in tandem. But since then, M0 has been on a wholly different trajectory. This indicates what economists call "hording": much money is stored as deposits at the ECB by commercial banks.Â
II- M1 in Transition: From Stability to Turbulence, 1998 to 2024
Since 1998, the M1 money supply in the Eurozone has experienced significant fluctuations, reflecting various economic cycles, global crises, and the monetary responses of central banks. This period can be divided into several key phases, each influencing the economy and inflation in the Eurozone in its own way.Â
1. Stability and Growth (1998-2007)
The introduction of the euro in 1999 marked the beginning of a new economic era for the Eurozone. During this period, the money supply, as measured by M1, increased steadily as the European Central Bank (ECB) managed to maintain inflation close to its target of 2%. This era was characterized by stable economic growth, low unemployment, and a well-functioning monetary policy. The ECB’s ability to balance the growth of the money supply with the needs of the real economy ensured that inflation remained under control, allowing the Eurozone to enjoy a period of relative stability.
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2. The Global Financial Crisis (2008-2010)
The financial crisis of 2008 disrupted this stability, leading to a severe economic downturn. In response, the ECB significantly increased the money supply through various monetary stimulus measures aimed at preventing a financial collapse. However, despite the rapid growth of M1, inflation did not spike as classical theories might predict. Instead, the Eurozone experienced a period of disinflation, and even temporary deflation, as demand collapsed and economic activity slowed. This period highlighted a critical insight: the relationship between money supply and inflation is not always immediate or direct, especially in the context of a financial crisis.
3. Post-Crisis and Quantitative Easing (2010-2019)
In the aftermath of the financial crisis, the ECB adopted unconventional monetary policies, including Quantitative Easing (QE), to inject liquidity into the economy. The goal was to stimulate economic growth and prevent deflation by increasing the money supply. However, despite the continued expansion of M1, inflation remained stubbornly low, often below the ECB’s 2% target. This disconnection raised questions about the traditional understanding of money supply and inflation. Economists observed that much of the excess liquidity was confined to financial markets rather than flowing into the broader economy, which kept consumer price inflation low while inflating asset prices.
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4. The COVID-19 Pandemic (2020-2021)
The outbreak of COVID-19 in 2020 led to an unprecedented economic response. Governments and the ECB implemented massive support measures, leading to a dramatic increase in the money supply. Despite this, inflation remained moderate throughout 2020 as global demand was suppressed by lockdowns and economic uncertainty. However, by 2021, inflationary pressures began to surface as the economy started to recover, supply chains were disrupted, and commodity prices surged. This period demonstrated the lag between monetary expansion and its impact on inflation, as well as the role of supply-side constraints in driving price increases.
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5. The Inflation Surge (2022-2024)
The years 2022 to 2024 witnessed a significant surge in inflation across the Eurozone, driven by a combination of factors. The war in Ukraine, global supply chain disruptions, and skyrocketing energy prices created substantial inflationary pressures. The massive increase in M1 during the previous years now began to fuel demand in an environment where supply was severely constrained. As a result, prices rose rapidly, prompting the ECB to pivot towards a tighter monetary policy. Interest rates were increased to curb inflation, marking a significant shift from the ultra-accommodative policies of the previous decade. This period underscored the risks of delayed inflationary effects following monetary expansion and the challenges central banks face in responding to such dynamics
The different economic phases since 1998 have shown that the relationship between money supply and inflation is neither linear nor immediate. However, another key phenomenon has emerged over these years: the shortening of monetary cycles.
Figure 3: Difference between actual consumer price index 1999-2023
Since the euro was introduced , inflation has averaged close to target, despite the recent surge .Difference between actual consumer price index and a steady 2 percent inflation path, 1999–202
III- Accelerating Monetary Cycles: Challenges and Implications
The analysis of monetary and inflation cycles since 1998, along with central bank actions, reveals a clear trend: monetary cycles have significantly shortened, moving from several years (often around 10 years) to shorter cycles of 1 to 2 years, especially since 2020. While this shortening is an adaptive response to a constantly evolving economic environment, it has major implications for economic stability, financial markets, and investment strategies, among other areas.
Increased Economic Instability: Shorter monetary cycles tend to exacerbate economic instability. When central banks frequently adjust interest rates or the money supply, businesses and consumers struggle to anticipate these changes and adapt their behavior accordingly. This unpredictability can lead to periods of economic growth quickly followed by slowdowns or recessions, making long-term planning more difficult for businesses.
Increased Financial Market Volatility: Financial market volatility is amplified by these shorter monetary cycles. Investors adjust their portfolios based on expectations of monetary policy, which can lead to rapid and significant fluctuations in asset prices. This increased volatility discourages long-term investments and pushes investors toward more speculative or short-term strategies, thereby increasing risks in financial markets.
Shortened Investment Cycles: Investment cycles are also affected by the frequency of changes in monetary conditions. In an environment where these conditions change rapidly, companies may hesitate to commit to long-term investment projects, fearing that financing costs will suddenly rise or that demand will become unpredictable. This can lead to underinvestment in large-scale projects and a focus on shorter-term investments, limiting innovation and long-term economic growth.
Decreased Predictability for Businesses: Businesses rely on a certain level of stability in economic and monetary conditions to make strategic decisions, such as expansion, hiring, or asset acquisition. Shorter monetary cycles reduce this predictability, making medium- and long-term planning more difficult. This can result in a reluctance to invest or an overreaction to economic changes, further exacerbating economic instability.
Impact on Consumers: For consumers, shorter monetary cycles mean more frequent fluctuations in interest rates on mortgages, consumer credit, and other forms of debt. This increased financial uncertainty can affect their consumption and ability to save or invest, which can slow down overall demand and impact economic growth.
Increased Risk for Monetary Policies: For central banks, these shortened cycles increase the risk of monetary policy errors. Frequent adjustments can lead to delays in the effects of policies, making it more difficult to achieve price stability and full employment objectives. Additionally, central banks may be perceived as less reliable or overly reactive, which could erode confidence in their ability to effectively manage the economy
Figure 4: Inflation and annual growth rates of M3 and M3 adjusted by real GDP growth
IV- M1 in Transition: From Turbulence to the Unknown, Scenarios Beyond 2025
As we learn from past and present monetary dynamics, it is crucial to look forward and consider potential scenarios for the evolution of the M1 money supply in the coming years. Several factors, both economic and political, could influence this evolution, and it is important to consider various hypotheses to anticipate the impacts on the economy and inflation.
Monetary Stability Scenario
In a monetary stability scenario, central banks, particularly the ECB, might choose to maintain a cautious approach to monetary policy, carefully balancing liquidity injections with the needs of the real economy. Under this hypothesis, M1 growth would be moderate, with an increase in the money supply corresponding to healthy and controlled economic expansion. This strategy could help avoid excessive inflationary pressures while supporting growth. Inflation would likely remain close to target levels, around 2%, allowing for more predictable economic management.
Monetary Expansion Scenario
In a context where economic shocks or crises could occur (such as a global recession or a new health crisis), central banks might revert to expansionary monetary policies. This could include renewed quantitative easing or ultra-low interest rates to stimulate demand. In this scenario, the M1 money supply could grow significantly, potentially fueling medium-term inflation risks, especially if stimulus measures exceed the needs of the real economy. Such a situation could lead to a repeat of the challenges observed between 2022 and 2024, with delayed inflationary pressures and the need for rapid monetary tightening.
Monetary Contraction Scenario
Another scenario, though less likely, could be one of monetary contraction, where central banks, faced with persistent inflation or the risk of economic overheating, choose to actively reduce the money supply. This could be achieved by reducing asset purchases, continuously raising interest rates, or other measures aimed at limiting credit and liquidity growth. In this case, M1 could stagnate or even decrease, which could slow economic growth in the short term but help stabilize prices. However, this scenario could also lead to deflation risks if the measures are too drastic.
Monetary Innovation Scenario
With the emergence of new financial technologies, such as central bank digital currencies (CBDCs), another hypothesis could be a transformation of the very structure of M1. The introduction of CBDCs could change the composition of the money supply and its circulation channels. This shift could have complex implications for monetary policy, the velocity of money, and inflation. In this scenario, central banks would have to navigate a new monetary landscape, with unique challenges and opportunities to stabilize the economy.
Conclusion
The analysis of monetary and inflation cycles in the Eurozone from 1998 to 2024 shows that these cycles have shortened, reflecting an increasingly dynamic and unpredictable economic environment. While this rapidity allows for effective responses to economic shocks, it also presents significant challenges for economic stability and investment strategies.
Increased volatility, reduced predictability, and the risk of discouraging long-term investments are some of the consequences of these shorter cycles. Therefore, investors, businesses, and policymakers must exercise vigilance and develop resilient strategies to navigate this context. Balancing the necessary responsiveness with long-term stability becomes essential.
In summary, although rapid adjustments in monetary policy are sometimes necessary, they require careful management to avoid lasting imbalances. Success lies in the ability to anticipate these challenges and formulate strategic responses that promote stable and sustainable economic growth.
Disclaimer Please note that articles may contain technical language. For this reason, they may not be suitable for readers without professional investment experience. Any views expressed here are those of the author as of the date of publication, are based on available information, and are subject to change without notice. Individual portfolio management teams may hold different views and may make different investment decisions for different clients. This article does not constitute investment advice. It is provided for information purposes only and does not constitute an invitation to invest. Please seek advice from your investment advisor before investing.
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