Macro Outlook

Janet Yellen’s $5.36 Trillion Speed Trap

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.

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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.

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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?

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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.

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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.