Money moves through an economy over time.
Let’s assume that you go to your local market and buy $10 worth of groceries. The store deposits your payment into its business checking account, and the bank uses this cash as part of its reserves to back up a loan to another consumer who purchases a new car. The car salesman earns a commission, which he or she uses to book a hotel room as part of a vacation.
Over time, the $10 that you spent at the grocery store will change hands in many transactions.
Economists call the number of times a dollar is used to buy goods or services over a certain period the velocity of money. The more transactions that take place over a specific time frame, the greater the velocity of money in the economy.
M2 is a measure of US money supply that includes bills and coins, traveler’s checks, funds in checking and savings accounts, certificates of deposit under $100,000 and money-market accounts for individuals. The velocity of M2 began to slow in 1997, a trend that has accelerated since the 2007-09 financial crisis and Great Recession. Money velocity stands at its lowest level since at least 1959.
The velocity of money serves as a proxy for consumers’ propensity to spend money instead of saving; this slowdown blunts the efficacy of quantitative easing and ultra-low interest rates—a major challenge for the Federal Reserve and other central banks.
Since mid-2008, the US Federal Reserve has pumped $3.58 trillion into the US banking system through several rounds of quantitative easing. Over the same time frame, US M2 money supply surged by $5.36 trillion, or 69.5 percent.
Nevertheless, the US economy has grown at a lackluster pace since mid-2008, and inflation has remained well below the Federal Reserve’s target of 2 percent.
Why hasn’t the Fed’s extraordinarily accommodative monetary policy and the growth in money supply bolstered the US economy or the inflation rate to anywhere near the same extent as in prior cycles?
The collapse in the velocity of money provides an answer to this quandary. Banks continue to hoard cash as excess reserves on deposit with the Federal Reserve, while consumers have pivoted toward saving. Base money, or the amount of US currency in circulation, has surged 78 percent to $1.47 trillion since mid-2008.
(Click graph to enlarge.)
With interest rates hovering near zero, the advantage of holding money in bank deposits instead of cash has diminished.
Money that isn’t spent or lent to businesses and consumers doesn’t generate economic growth. A slowdown in the velocity of money reflects a reduced propensity for banks to lend and consumers and businesses to spend. In this environment, a greater increase in money supply is required to stimulate incremental economic growth.
The quantity theory of money holds that MV = PQ. That is, money supply (M) times the velocity of money (V) equals the prevailing price level (P) times the quantity of goods and services produced in the economy.
According to this equation, an increase in money supply and constant velocity should produce a commensurate increase in inflation and/or the quantity of goods and services produced. Although the Federal Reserve has increased money supply significantly since the Great Recession, the slowdown in M2 velocity has offset this tailwind, limiting inflation and economic activity.
Money velocity doesn’t just have consequences for the economy. The stock market also affected, since not all companies and stocks respond the same to low inflation expectations and reduced general economic activity.
Capitalist Times Premium portfolios take this into account by strategically adding stocks that can weather this environment, as well as the use of select hedges to manage and protect your returns during downturns. Become a subscriber today to invest smarter during a slow money velocity time.
Elliott H. Gue is founder and chief editor of Capitalist Times and Energy & Income Advisor.