With the DOW blowing by milestones I went looking for other things that were at record levels. The first one that I looked at was M2. No surprise at all, M2 is bigger than ever. Charts of the long and short term trajectory of money supply:
The money supply is $3T higher than it was at the start of the 2008 recession. GDP is up $2T.
There is another component of M2. It has me baffled. It too is at a record. In this case it’s a record low. I’m sure this important. I don’t know why it’s happening. I don’t know what the consequences of this will be. This chart is screaming something:
My thoughts on the chart:
- It’s fairly clear that sharp declines in the velocity of money is consistent with periods of recession. But..
- If recessions are the cause of the decline in velocity, what the heck is going on today? We are now three years out of recessions, and velocity keeps dropping.
- Behind each of the recessions is the Federal Reserve. To offset a slowdown in the economy, it drops interest rates. When interest rates fall, velocity declines.
- As interest rates have been forced to zero for years past the last recession, the velocity of money has continued to decline.
- There are no periods in history where sustained economic expansion has occurred while money velocity is declining.
If you buy into my (admittedly un-scholarly) assessment of money velocity, then you might conclude:
* The Fed’s ZIRP policy has outlived its usefulness as a policy tool.
* The Fed’s policy on Forward Guidance for short-term interest rates (another two years of ZIRP) is accelerating the decline in money velocity, and therefore counter productive.
Clearly, Bernanke and the other Fed Doves don’t think there is a connection between record low money velocity and ZIRP. In fact, they must believe precisely the opposite. These folks are aware of the collapse in velocity, they know that this drop is a drag on the economy (particularly inflation), yet they have committed themselves to a policy that (IMHO) insures that money velocity stays historically low. Go figure.
One final thought on money velocity – it will return to a more normal level at some point. This may not happen until years into the future when monetary policy goes off “Fast Forward”. But it will happen.
When it does, the high octane gas that is now M2 and not moving; will become the bloated M2 that is moving. Another dumb question comes to mind.:
The Fed has said that it will not back off until inflation gets to 3%. But when the Fed does back off, money velocity should accelerate very quickly – and this should give inflation another big boost. So when the Fed finally does respond to rising inflation, its actions will light a fuse on more inflation.
The Fed Doves are not thinking of that scenario. If they did, they would be not so confident in their ability to control the outcome. That, or they’re bluffing.
Thank you for presenting this as it is very important. Since the Feb 11 report M2 has been falling (10418.6 to 10389.9) and M1 has been falling since Feb 4 (2491.9 to 2460). M3 as reported by Bart has also been falling for the last three weeks (15821.72 to 15613.31).
M1 M2 link http://www.federalreserve.gov/releases/h6/Current/
Barts M3 link http://www.nowandfutures.com/articles/20060426M3b,_repos_&_Fed_watching.html
I agree that inflation will show up in a measurable fashion. By measurable I meant the fed could measure it not just the masses. It most likely will not be hyper inflation.
Thank you for all your hard work in publishing these great economic stories that will soon be economic events. .
The decline in M2′s velocity is no mystery. With M2 growing much faster than nominal GDP, its velocity must decline by definition.
spot on response. It’s startlingly that no Street economists mention the death spiral of money velocity. I guess that’s what happens when no one does original research. If or when money velocity creeps back up it’ll be too late to prepare for the inflation that will follow. Gold and guns, man. Gold and guns.
I suppose you know that the St Louis Adjusted Monetary Base (basically the Fed’s balance sheet) is also at record highs these days: http://research.stlouisfed.org/fred2/graph/?s%5B1%5D%5Bid%5D=BASE
Bruce: The numbers are similar to the great depression. Basically MV=GDP, that is money times velocity is gdp. We know personal income is down almost 9% from the 2007 peak (54K vs present 50K). The reason it’s not down further is due to fiscal stimulus effects, plus growth in the money supply, but as monetary velocity craters and the fed stops printing, you will see an acceleration in the downward gdp number. We will have to watch the next report for Q1 on 4/30. As government stimulus ends, it will show that monetary stimulus is not working and the gdp trend will follow velocity more closely. Just a different way at looking at your article
Lakshman Achuthan over at ECRI has been insistent on the “recession is happening now” theme for well over a year already. I’m not sure if he is even focused in on M2, but it doesn’t look like any kind of recovery is occurring where I live.
I would argue that the Velocity is the important variable, and the quantity measures are residuals. I would suggest that the Fed is responding to declining velocity with QE programs. If they didnt, the monetary situation would tighten and some damn bank would go bust again. The Bear, Lehmans, I guess the next one in line for trouble is Stanleys. Actually scratch that. The next bank to go bust would be European.
Looked at from this point of view then sure, ZIRP is unfortunate. But they are trying to hit two targets. 1) Prevent money squeeze. 2) Ensure banks are profitable so they can earn some capital. No one has worked out that the two may not be compatible. The banks are earning their VIG out of our hides, and the ordinary people cant make a living and pay the banks 300bps of spread.
You are right, it wont end well. But i doubt the problem ends up being inflation. We would be lucky if thats the outcome. Usually its war.
From what I read here, there does not seem to be a common understanding of what velocity of money really is. Is it an independent variable that can be measured on its own, or, is it a calculated value, i.e. V= GDP/M? It seems to me that it is simply a calculated value. So if GDP growth is minimal and M is increasing significantly then V will have to go down. Are there any correct answers out there? Bruce?
let me google that for you…this is from the FRED website:
http://research.stlouisfed.org/fred2/categories/32242
Money Velocity
Velocity is a ratio of nominal GDP to a measure of the money supply (M1 or M2). It can be thought of as the rate of turnover in the money supply–that is, the number of times one dollar is used to purchase final goods and services included in GDP.
Thanks Econ. It seems then that V (Velocity of money) is a calculated value and not a measured value. So if GDP is stagnant and M goes through the roof then V, by definition, has to go down. So I’m not sure what Bruce is getting at here.
Let’s look at this thesis: in aging societies, low interest rates lead to low consumer price inflation. Why? Because retirees have less cash flow and therefore spend less money. The central banks’ attempt to pump up lending by lowering rates may produce asset price inflation, but that does not for the most part filter into the real economy.
If low rates led to consumer price inflation, it would have happened by now.
BWDIK,
Yeah I think you have a point. I dont know if you are familiar with Modern Monetary Theorists but the argument you just made sounds a bit like one of theirs. They might also say something like, “Interest paid by the government is cash flow into the retirees. Drop that rate to zero and you force them onto cat food. How could forcing seniors to eat catfood be considered likely to boost their consumption? Of course it doesnt. Its meant to boost the consumption of those people who are heavily in debt. Sadly since they dont have jobs/since they pay the same rate on their credit card debt – it doesnt matter how low you put rates.
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I’ve been trying to figure out the correlation between the economy and the velocity of M2. It seems like the two correlate and in theory, more money going around allows the economy to seem “functioning”.
http://ftalphaville.tumblr.com/post/42424325420/liquidity-charted
Alphaville compared this to credit demand and supply. Correlation? A slight one with demand, but steps out of sync after the beginning of the Millennium.
What I don’t understand is the velocity of money doesn’t explain the golden economy of the 1950s/1960s. The dollar was worth much more then and GDP growth was double what it is after the volcker recession. Maybe something to do with the monetary supply? But if that was the case wouldn’t the chart be at its highest points then. You can’t tell me the greatest period of growth in this country was the 90′s. LAME. WEAK.
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