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Falling U.S. money supply creates downturn fears Add to ...

The money supply in the United States is doing something that almost never happens: it's shrinking, after taking into account inflation.

Similar episodes in the past have usually been scary times for investors. Declines in the amount of money in circulation have coincided with recessions, and some analysts looking at the current trend say it is a harbinger of trouble. Despite signs that the U.S. is in recovery, they worry that the money supply numbers indicate the economy remains vulnerable to the feared double-dip downturn, or is close to experiencing deflation.

While not everyone is so gloomy, some economy watchers say the money supply trend still bears attention because it indicates the U.S. credit system isn't yet back to full health. This suggests the business upturn under way is going to be muted, unlike the sharp rebounds that normally accompany recoveries from steep recessions.

The anemic money supply "flies in the face of those who believe that we are in, or can have, a really strong economic recovery," said Martin Barnes, managing editor at BCA Research, an investment research firm based in Montreal. "I don't believe that we will, or can, while the money and credit environment is so fragile and so weak."

The U.S. money supply measure known as M2 has been negative, after taking account of inflation, for much of the year. An even broader measure, called M3, has been falling since late last year, and is now shrinking by about 5 per cent.

The worst instance of a contracting money supply on record occurred during the Depression in the 1930s, but weakness in the money supply also coincided with severe downturns during the 1970s and 1980s.

Economic prognosticator Ian Gordon contends that the slumping figures are a sign that deflation, or falling consumer prices, is around the corner.

"We're moving into deflation," said Mr. Gordon, president of Longwave Analytics, an economic forecasting group based in British Columbia. "I'm absolutely convinced that's what we're going into."

While most people think of the money supply as the bills and change in their pockets, it also includes such items as balances in bank chequing and money market accounts, and institutional money market shares.

Banks take these deposits and use them to fund loans. When money supply shrinks, it indicates some combination of financial institutions writing off loans and being unwilling or unable to lend, and consumers being too tapped out to borrow, causing economic weakness and putting downward pressure on prices.

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One sign of this process at work may be that the U.S. economy is perilously close to experiencing falling price levels. Although the consumer price index is up about 2 per cent over the past year, in March it hardly rose at all. According to figures released this week, it was up only 0.1 per cent; excluding volatile food and energy prices, it was unchanged.

Another prognosticator worrying about the money supply is John Williams, an economist based in Oakland, Calif., who publishes Shadow Government Statistics, a newsletter on U.S. government financial data.

Mr. Williams views the money supply as a leading economic indicator. With it in decline, business conditions are far weaker than commonly thought by investors, and the current rally in the stock market is a head fake, he believes.

Money supply is "shrinking year over year," Mr. Williams said, adding that this does not happen outside of recessions, or the beginning of downturns. "What we're seeing with the money supply now is that it's telling us that we're in for a double dip."

Although central banks were once big proponents of watching the money supply for clues on the direction of the economy, they have recently been playing down the importance of the figures.

The U.S. Federal Reserve even stopped publishing figures on the M3 - one of the widest measures of the money supply - in 2006, but Mr. Williams has continued to estimate it, using data still issued by the Fed.

Mr. Barnes of BCA Research said he believes the economy can manage to grow in the face of a slump in the money supply, driven by the spur of low interest rates, huge government deficits and the recent resumption of U.S. employment growth. He said only an unexpected shock, such as surging oil prices, or a policy error, such as premature tightening of monetary policy, will trigger a renewed recession.

But he thinks the weak money supply means the upturn will remain subdued. That, in turn, will force the Fed to keep interest rates low. The Fed "is going to move very, very cautiously here in terms of backing away from its easy stance," Mr. Barnes said.

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