The relationship between money supply and velocity has significant implications for security markets going forward, particularly as it relates to inflation. One Federal Reserve Bank Plaza, , published 1969. 1 highlighted above to see the way to derive GDP from M2 money stock and the velocity of the M2 money stock. M2 consists of M1 plus: (1) small-denomination time deposits (time deposits in amounts of less than $100,000); and (2) balances in retail Money Market Funds. Among other measures, such as increasing interest rates and quantitative tightening (reducing Feds balance sheet), the Fed will also have to bring down M2 money stock. Explore resources provided by the Research Division at the Federal Reserve Bank of St. Louis. Thus, it is precisely the sharp decline in velocity that has offset the sharp increase in money supply, leading to the almost no change in nominal GDP (either P or Q). When inflation is high, prices for goods and services rise and thus the purchasing power per unit of currency decreases. Therefore, a huge increase in the denominator naturally results in a lower figure without the same corresponding increase in GDP. 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. Then they can buy something else with it. That said, nothing goes down in a straight line, but intermittent rallies should be sold into. That peak you see in the middle of the chart shows, for example, that in 1997 every dollar of M2 cash was associated with 2.2 dollars of GDP (i.e., it turned twice in that year). The chart above plots the yearly M2 Growth Rate and the Inflation Rate, which is defined as the yearly change in the Consumer Price Index (CPI). Increasing money velocity rates imply a higher number of transactions and higher aggregate demand. Most surprising of all: how in the world could the Fed not see it? The M2 money supply grew at annualized rates exceeding 20 percent throughout much of 2020. Releases from Federal Reserve Bank of St. Louis, More The velocity of money can be calculated as the ratio of nominal gross domestic product (GDP) to the money supply (V=PQ/M), which can be used to gauge the economy's strength or people's willingness to spend money. Youll notice the greater correlation and then decoupling. Federal Reserve Bank of St. Louis, It spiked in March 2020 and has remained at high levels since then. Advanced purchases drive prices higher while consumers feel motivated to buy before prices rise again. But The middle part of the chart, from 1991 2000, shows a counter-intuitive separation of money velocity and inflation. The contraction of the velocity of circulation of money explains why the massive increase of the monetary base by the American central bank has not led to a price inflation. I can think of two reasons. This is how velocity of money reflects the overall strength of an economy. R= -0.98 R^2 = 0.97. The personal saving rate is a primary indicator to track velocity of money and inflation. Implies, the number of transactions (see definition of the velocity of M2 money stock above) between individuals has been going down. All this certainly explains why the S&P keeps making new highs . But after a while, the public's demand for holding so much cash in the bank weakened; people began spending the cash and that drove nominal GDP higher by leaps and bounds, thus increasing the denominator. To further understand this relationship, lets take a look at how M2 money stock and the velocity of M2 money stock have played out since 1999. In the U.S., the Feds dual mandate is to balance unemployment and inflation. Then, why velocity of money may not mean anything for inflation after all. The problem is that velocity of money is never constant. Why even bother with it? But by Spring of '21, life for many was slowly returning to normal, and people realized they had no reason to hold onto tons of money sitting in the bank earning little or no interest. Further, it is lower than any time since 1960. Copyright Broken Pie Chart Podcast. He relayed a story to us that earlier in his career US money supply data, released every Thursday afternoon, was sometimes a market moving event. The formula can also be expressed as follows: The formula shows that expansionary monetary policies (increase of M) can actually cause lower velocity of money if the real economic output is constant. Opinions expressed are those of the author. Last week CNBC had some talk about 2022 likely to have the first ever decline in the M2 Money Supply. That allows markets to feel more certain about corporate earnings leverage and growth while also enjoying the valuation benefits of lower rates. This week's stronger-than-expected February inflation data from France, Spain and Germany has led traders to price European Central Bank rates peaking near 4%, following similar moves in U.S . Time-series GDP deflator and money velocity, from Friedman's 2004 article, "The Fed's Thermostat." It isn't clear if velocity is a measure of GDP/M2 or GNP/M2, but anyway GDP should in general be transacted in US dollars. Year-over-year M2 growth is -1.7%, and 6-mo annualized growth is -3.4%. issn: 00028282.http://www.jstor.org/stable/1805778. Beginning May 2020, M2 consists of M1 plus (1) small-denomination time deposits (time deposits in amounts of less than $100,000) less IRA and Keogh balances at depository institutions; and (2) balances in retail MMFs less IRA and Keogh balances at MMFs. High money velocity is usually associated with a healthy, expanding economy. Put it simply, every time you spend a dollar bill someone else receives it. Why? Why was there only a handful of economists who commented on it, as I noted a year ago? Trillions of dollars injected into the economy by the Federal Reserve has not caused an increase in GDP or inflation. Within the broad range of available tools for technical analysis, there is a pattern that, in my opinion, fits perfectly with the chart of money velocity shown below. Some of our partners may process your data as a part of their legitimate business interest without asking for consent. In other words, it is the number of times one dollar is spent to buy goods and services per unit of time. Monetary expansion policies do not necessarily increase the velocity of money. If not cycling through transactions, where did all that newly minted money go? He specialized in analysis of Federal Reserve policy and interest rate forecasting, and spearheaded the firm's research into Treasury Inflation Protected Securities (TIPS). Supply also matters here, and that issue tips in favor of higher prices for items like new cars and trucks. Before May 2020, M2 consists of M1 plus (1) savings deposits (including money market deposit accounts); (2) small-denomination time deposits (time deposits in amounts of less than $100,000) less individual retirement account (IRA) and Keogh balances at depository institutions; and (3) balances in retail money market funds (MMFs) less IRA and 1956. By clicking submit, you agree that you have read and understand ourTerms of Service,SubscriptionAgreement, andPrivacy Policy, and hereby agree to be bound by them. The Fed doesn't need to do more than they already have. Explore resources provided by the Research Division at the Federal Reserve Bank of St. Louis. That doesnt mean, however, that M2 doesnt form part of the quantity relationship. annualized growth rate of M2, which is now -3.4%, down sharply from a high of over 40% in August of 2020. When there are more transactions being made throughout the economy, velocity increases, and the economy is likely to expand. and (2) balances in retail Money Market Funds. The answer lies in the private sectors dramatic increase in their willingness to hoard money instead of spend it. 2015. Businesses and capital allocators may find it prudent to consider diversifying into non-U.S. initiatives and assets to better navigate this domestic risk since the extraordinary monetary growth phenomenon experienced in the U.S. has been less pronounced in most other developed economies. Start your 2-week FREE trial to see our thought-provoking daily work on markets, data & disruption! Forbes Finance Council is an invitation-only organization for executives in successful accounting, financial planning and wealth management firms. . Low money velocity is usually associated with recessions and contractions. This dynamic can have a significant effect on inflation indexes. Steve H. Hanke, Professor of Applied Economics at the John Hopkins University, has been an outspoken critic of the Fed and its failure to foresee that the exploding M2 would cause inordinately high inflation. That doesn't mean, however, that M2 doesn't form part of the quantity relationship. Series from Money Velocity. In other words, MZM money is M2 money minus time deposits. Data in this graph are copyrighted. As a reminder, M2 money is basically cash, checking and retail money market balances and velocity is GDP divided by M2. View more of Maria's work. Monetarism is a school of thoughtwith Milton Friedman being one of its prominent members that underscores the importance of money supply. But if theyre more cautious and only tip toe back to their 2019 lives, then velocity will only slowly increase and inflation should be less of a concern. That peak you see in the middle of the chart shows, for example, that in 1997 every dollar of M2 cash was associated with 2.2 dollars of GDP (i.e., it "turned" twice in that year). Further Information Those are important but dont necessarily tell the whole story on the state of the economy, much less the direction to which things may be headed. When the velocity of money declines, it can even offset an increase in money supply and lead to deflation instead of inflation. The close relationship between inflation and velocity of money is typically driven by consumer psychology. Reuters Summary Major U.S. indexes rise; FANGs, transports, chips outperform Cons disc leads S&P sector gainers; real. Federal Reserve Bank of St. Louis; When it goes up, M2 will. M2 velocity has collapsed, but the increase in M2 money supply has aligned with that in other financial assets. When inflation is high, people spend their money quickly, before it loses more value, which, in turn, exacerbates inflation. Do we simply have special circumstances that have broken down this relationship? Not a huge surprise, that, given Fed bond buying and a sluggish post-Great Recession recovery. Maria Arias is a FRED Data Engineer at the St. Louis Fed. M2 contained non-M1 components which are contractionary. Money velocity rate has been falling for about twelve years before collapsing in April 2020. Chart #5 shows the ratio of M2 to nominal GDP, a ratio I have called "money demand." In other words, it is the number of times one dollar is spent to buy goods and services per unit of time. For each quarter, CPI inflation is plotted on one axis (horizontal) and M2 velocity is plotted on the other (vertical): Not much of a relationship can be found here. One, M2 is partially endogenous to inflation (well, really NGDP. One, as a 20 percentage point growth in the ratio of the money supply (M2) to gross domestic product (GDP) in a five-year period; Two, as a 60 percent nominal growth in M2 in a five-year period; . Chart #2 shows the 6-mo. One of the ways the Fed achieves its goals is by manipulating M2 money stock. 5 (1980): 10051014. Skip to main content. The opposite is also true: Money velocity decreases when fewer transactions are being made; therefore the economy is likely to shrink. Is this happening to you frequently? Chart #4 compares the growth of M2 with the year-over-year change in the CPI, which is shifted one year to the left in order to show that money growth leads inflation by about one year. The past three years have been by far the biggest roller-coaster ride in our monetary history. There are two ways for M2/GDP to decline: 1) slower M2 growth and/or 2) faster nominal GDP growth, which almost certainly entails higher inflation (because nominal GDP has two components:. Learn more about the Econ Lowdown Teacher Portal and watch a tutorial on how to use our online learning resources. MacMillan and Company Limited. To ease credit during the pandemic, the central bank helped . See why for yourself by starting a 2-week FREE trial below. Youre probably familiar with economic data like unemployment figures, Fed funds rate and the inflation rate. The frequency of currency exchange can be used to determine the velocity of a given component of the money supply, providing some insight into whether consumers and businesses are saving or spending their money. During the Great Financial Crisis (GFC), MV went from a high of 1.989 at the GFCs start in Q3 2007 to a low of 1.712 by end of the crisis in Q1 2009. This blog offers commentary, analysis and data from our economists and experts. The Fed has seriously distorted money supply. As we saw above, this is the case of the money velocity. In the most recent quarter (Q4 2021), the velocity of M2 money stock has slowed to a stunning 1.123. To understand why this ratio is important, we will highlight the equation that defines the relationship between M2 money stock, GDP, and the velocity of M2 money stock: The Velocity of M2 Money Stock = GDP / M2 Money Stock - (Eq. If for some reason the money velocity declines rapidly during an expansionary monetary policy period, it can offset the increase in money supply and even lead to deflation instead of inflation. The velocity of money is the frequency at which one unit of currency is used to purchase domestically- produced goods and services within a given time period. We explore the stock, flow and velocity of money, as well as signs of weakening aggregate demand, in this week's note. In my opinion this can be viewed as a strong climax signal that cannot be ignored. You may opt-out by. The velocity of money refers to the number of times consumers spend each dollar in a year. Are labor supply and labor demand out of balance? A reduction in M2 would most certainly slow down GDP and even lead to a recession. FRED Series Velocity of M2 Money Stock. Thus followed a surge in spending at a time of supply chain shortages, and it all came together to create a perfect wave of higher inflation. While M2 velocity is currently at historical lows, inflation is clearly not high. If you would like to change your settings or withdraw consent at any time, the link to do so is in our privacy policy accessible from our home page.. The linked post was written on February 3, 2022, and unsurprisingly, the U.S. printed a negative 1.4% GDP read. By clicking submit, you agree that you have read and understand ourTerms of Service,Subscription Agreement, andPrivacy Policy, and hereby agree to be bound by them. Review historical increases in the money supply Money supply and inflation Fiscal stimulus like sending checks out vs the Fed monetary expansion What is the velocity of money? It supports the intervention of central banks to manage business cycles by targeting an adequate growth rate of money supply. The velocity of money, namely the rate at which it changes hands, as a percentage of gross domestic product has been sliding since 1995, he observed. To view the purposes they believe they have legitimate interest for, or to object to this data processing use the vendor list link below. Investors have long been confounded by the absence of inflation in the U.S. since low interest rates and M2 growth should lead to higher price levels all else equal. Federal Reserve Bank of St. Louis, Note how money velocity greatly increased when inflation exceeded 14% in the 1980. Velocity dropped swiftly as M2 rose following the responses to the crises, partially because of funds being held by banks. Please. While there may be a broad range of drivers behind the motivation to buy, what consumers expect future inflation to be, inflation expectations, is certainly a major one. There are several components of the money supply,: M1, M2, and MZM (M3 is no longer tracked by the Federal Reserve); these components are arranged on a spectrum of narrowest to broadest. The press, the media, and many market pundits are now saying inflation is imminent. The information provided here is not investment, tax or financial advice. But the actual velocity has gone down by 5.85 points, 69 times larger than predicted. R = -0.63 R^2 = 0.40. M2 Money Supply Shrinking vs Inflation | Money Velocity Irrelevant?. When consumers save more, the number of transactions in the economy declines rapidly while the velocity of money drops. Dynamic can have a significant effect on inflation indexes time you spend a bill., from 1991 2000, shows a counter-intuitive separation of money drops in a lower figure without the corresponding! The quantity relationship on inflation indexes higher while consumers feel motivated to buy and! 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More than they already have a significant effect on inflation indexes yourself by a., analysis and data from our economists and experts ways the Fed does n't need to more! Market funds a ratio I have called `` money demand. on it, I. Gdp, a ratio I have called `` money demand. without the same increase... Fed does n't need to do more than they already have for security markets going forward particularly... Velocity is usually associated with a healthy, expanding economy we saw,! Shows a counter-intuitive separation of money and inflation for yourself by starting a 2-week FREE trial to our... Adequate growth rate of money drops why the S & P keeps making new highs to derive GDP from money! The Research Division at the Federal Reserve has not caused an increase in money supply has aligned that. Buying and a sluggish post-Great Recession recovery more, the U.S., the number of transactions the., shows a counter-intuitive separation of money supply Shrinking vs inflation | money.. 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