Should we Worry that Velocity of Money is plunging?

Some writers have attributed slow GDP growth in the US to the plunging velocity of money.

In layman’s terms, the velocity of money is the ratio between your bank balance and the amount you spend. For the economy as a whole, it is measured as the ratio of GDP (or national income) against the total stock of money (or money supply).

When the economy is hot, consumers have a higher propensity to spend — or invest in the latest hot stock — and the ratio normally rises. When the economy cools, the ratio falls.

If the ratio was fixed, the job of central bankers would be simple: print more money and GDP would rise.

M1 Money Supply and GDP Growth

Unfortunately that is not the case. GDP growth has remained slow, post-2007, despite a sharp boost in the money supply.

M1 is a narrow definition of money: cash in circulation plus travelers checks, demand deposits (at call) and check account balances.

The ratio of GDP to M1 money (or M1 Velocity) has almost halved, from a 2007 high of 10.7 to a current low of 5.5.

M1 Money Supply and GDP Growth

Does this mean that consumers are feverishly stuffing cash into mattresses as the economy goes into a death-dive or is there a more rational explanation?

Examine the above chart more closely and you will see a clear relationship until 1980 between the velocity of money and interest rates (in this case the Fed funds rate). When interest rates rise, the velocity of money rises. So when interest rates fall, as they have post-2007, to near zero, the velocity of money should fall. As it has done.

The anomaly is not the current fall in the velocity of money but the rise in velocity of money between 1990 and 2000, when interest rates were falling. There are two explanations that I can think of. One is the digital revolution, with the advent of online bank accounts and automated clearing of business checking accounts which enabled depositors to minimize balances in non-interest bearing accounts. Second, is the rapid growth of money market funds which fall outside the ambit of M1 and M2.

Velocity of money measured as GDP/MZM gives a clearer picture, with velocity rising when rates rise and falling when rates fall. MZM is M1 plus all savings deposits and money market funds that are redeemable (at par) on demand.

M1 Money Supply and GDP Growth

We should expect to see the velocity of money recover as interest rates rise. If that doesn’t happen, then it will be time to worry.

Strange as it may seem, we could witness something really unusual: if higher interest rates stimulate GDP.

Why QE is not working

Lars Christensen, Chief Analyst at Danske Bank, quotes David Beckworth in this lengthy but excellent 2011 paper on Market Monetarism — The Second Monetarist Counter-­revolution:

“…..Declines in the money multiplier and velocity have both been pulling down nominal GDP. The decline in the money multiplier reflects: (1) the problems in the banking system that have led to a decline in financial intermediation as well as (2) the interest the Fed is paying on excess bank reserves. The decline in the velocity is presumably the result of an increase in real money demand created by the uncertainty surrounding the recession. This figure also shows that the Federal Reserve has been significantly increasing the monetary base, which should, all else equal, put upward pressure on nominal spending. However, all else is not equal as the movements in the money multiplier and the monetary base appear to mostly offset each other. Therefore, it seems that on balance it has been the fall in velocity (i.e. the increase in real money demand) that has driven the collapse in nominal spending.”

Beckworth continues:

“[the] sharp decline in velocity appears to be the main contributor to the collapse in nominal spending in late 2008 and early 2009 as changes in the monetary base and the money multiplier largely offset each other. It is striking that the largest run-­ups in the monetary base occurred in the same quarters (2008:Q3, 2008:Q4) as the largest drops in the money multiplier. If the Fed’s payment on excess reserves were the main reason for the decline in the money multiplier and if the Fed used this new tool in order to allow for massive credit easing (i.e. buying up troubled assets and bringing down spreads) without inflation emerging, then the Fed’s timing was impeccable. Unfortunately, though, it appears the Fed was so focused on preventing its credit easing programme from destabilising the money supply that it overlooked, or least underestimated, developments with real money demand (i.e. velocity). As a consequence, nominal spending crashed.”

Christensen concludes:

Subsequent events have clearly proven Beckworth right and it is very likely that had the Federal Reserve not introduced interest on excess reserves then the monetary shocks would have been significantly smaller.

From Market Monetarism – The Second Monetarist Counter-­revolution