Commentary Directory

Euro Area Money Supply Contracts for the First Time Since 2010

Jacob Hess
August 28, 2023

The annual growth of M3 money supply in the euro area turned negative for the first time since May 2010. In July, the M3 growth was -0.4% YoY, down from 0.6% YoY in June. The growth of the less broad measure of money supply, the M1 monetary aggregate, continued to trend at all-time lows, setting a new record low of -9.2% YoY. Both of these values represent the unprecedented level of monetary tightening in the euro area economy as the ECB tightening cycle matures. The tightening was evident in the continued contraction in both credit to the private and public sectors. Credit to the government has had a negative effect on overall money supply growth since April of this year.

From ECB

The tighter financial conditions have caused a significant slowdown in lending as was largely expected. The growth of household loans in July reached its lowest point since October 2015 at 1.3% YoY. Similarly, the growth of loans to non-financial corporations slowed significantly to 2.2% YoY (from 3.0% YoY in June) which is the lowest since September 2016 (when not considering the pandemic lows). What is most jarring about these trends is the speed of the deceleration in loan growth. For example, less than a year ago, corporate loan growth was at its peak at 8.9% YoY in October 2022. The rate of deceleration is reminiscent of the sharp easing in loan growth during the financial crisis in 2008-2009. It is no surprise that this intensity of liquidity withdrawal is causing a sharp deterioration in the economic outlook; in fact, it is also quite surprising that a significant GDP contraction has not occurred already.

This data comes after ECB President Christine Lagarde spoke at the annual Jackson Hole Economic Policy Symposium on structural shifts in the global economy. Specifically, she mentions the new tightening in labor markets, the transition in energy generation toward renewables, and a deepening geopolitical divide. She points out that the new environment created by these shifts "sets the stage for larger relative price shocks than we saw before the pandemic" which demands central banks are more attentive to volatility. Despite structural changes, there was no backing down from the initial inflation targets: "We must and we will keep inflation at 2% over the medium term."

In total, the speech maintains the strong hawkishness that the ECB has represented since the start of its hiking cycle. There is a clear admission that inflationary pressures are much higher than the pre-pandemic period and that these pressures are possibly new long-term threats to price stability. But because Lagarde and the ECB are not giving themselves more leeway on the 2% inflation target, it is likely that they see a higher equilibrium long-term policy rate compared to the Great Recession era when inflation struggled to reach the 2% target due to underwhelming price growth. Lagarde ends with the closest thing to policy guidance in the speech: “In the current environment, this means – for the ECB – setting interest rates at sufficiently restrictive levels for as long as necessary to achieve a timely return of inflation to our 2% medium-term target.”

According to the reading of M3 money supply growth in July, the broader money supply has just started contracting. Loan growth to households and non-financial corporations is low, yes, but it is still expanding at an annual rate. It seems clear that the ECB is not yet satisfied with this level of financial tightening, and ECB members will perceive it necessary for stronger tightening to get inflation back where it wants to be. The hiking cycle is probably nearing its end, but that doesn’t mean that a shift towards rate cuts or dovish policy is coming. In fact, it would not be surprising if Lagarde and the ECB accept a GDP contraction and even possibly a full-on recession in the next 6-9 months if that is what it took to normalize elevated inflation.