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The Velocity of M2 Money

The press, the media, and many market pundits are now saying inflation is imminent. So, if everyone believes it, so it must be true. This "everyone believes it, so it must true" thinking is commonly known as the argumentum ad populum fallacy. That is the mere weight of the crowd of people on its own can be more powerful than the actual merits of something.

As human beings and social creatures, we know that it is extremely difficult to challenge something that most people believe in. It is human nature to elicit an automatic and immediate response to such situations with "that's just how it, so I will accept that this must be true".

So, if everyone believes something to be true, it may very well turn out to be true. But that, by itself, is not enough to make it true. It is simply not a good justification for one to blindly accept the majority and the popular view, which often tends to be uninformed/unthinking, without performing your own due diligence. Developing your own thinking and most importantly standing by our conclusions often takes strong will and discipline.

With the above thoughts in mind, we will attempt to reasonably determine if indeed inflation is just around the corner as so many believe, or is there other forces at work. Turning to my background as an Economics major, I recall an interesting economic indicator commonly referred to as the velocity of the M2 money stock. I believe this is one of the better economic indicators to uncover real economic activity.

The velocity of M2 money continues to record all-time lows. Does this then imply a relatively weak US economic environment or even a deflationary cycle rather than a sustainable longer-term rising inflationary trend?

If you recall from your Economics 101 there are several components of the money supply including M1, M2, M3, and MZM (money with zero maturity). M1 is the narrowest component. It is comprised of the currency in circulation, typically notes and coins, traveler's checks, demand deposits, and checkable deposits. The broader M2 component includes M1 plus saving deposits, certificates of deposit (less than $100,000), and money market deposits for individuals.

FRED or the Federal Reserve Economic Data of St. Louis FED states that "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 timeframe". In other words, it records the number of times one dollar is spent to buy goods and services for each unit of time. The frequency of currency exchange is important as this helps to determine the velocity of a given component of the money supply and gives us insights into how often financial assets are switching bands within the economy or whether consumers and businesses are saving or spending their money.

Based on the above, one can conclude that when the velocity of money is increasing (trending up), then more transactions are occurring between individuals in the economy. An increase in money velocity can indicate a strong or healthy real economy. On the other hand, a decline in money velocity can also indicate a weak or deteriorating real economy where the money is not changing hands at a robust rate.

With the FED pursuing aggressive monetary easing, it has led to a surge in the monetary base/money supply. Its massive purchases of Treasuries, Corporate Bonds, MBS, and the ending program to small businesses (PPP) have provided the financial markets with enormous liquidity, but it has also resulted in FED's balance sheet ballooning to unprecedented levels ($7 trillion). Historically, rapid money growth suggests a booming economic growth and soaring inflation. But it is not doing so this time, because uncertainties surrounding the COVID-19 pandemic, US Presidential Election, and U.S. and China trade tensions have also led to individuals hoarding cash and turning to the safety cash substitutes. 

Is the normal historical relationship still applicable in today's new market environment?

Since the velocity of the M2 money stock has declined to new lows we need to delve deeper into the relationship between GDP and the money supply and the velocity of money to better understand the underlining forces at work in the economy.

If you recall from your Economic studies the formula for GDP = Money Supply x Velocity of Money or hence, the Velocity of Money = GDP/Money Supply.

Based on the above formula, if the GDP growth trend is growing at a slower pace (due to the COVID-19 pandemic, recent US recession, trade tensions, and Presidential Election) in contrast to the rapid rise in money supply growth rate (due to FED expansion programs and the government fiscal policies) then the money velocity will continue to decline even if GDP growth begins to stabilize.

The pertinent question then becomes - is the decline in the velocity of money a true reflection of whether the US economy is actually weakening (deflationary) as outside forces such as FED monetary easing and the Government fiscal policies by dramatically skewing the monetary base/money supply.

Enclosed below are the Velocity of M2 Money Stock chart dating back to the 1960s as well as the M2 money stock, courtesy of FRED – Federal Reserve Bank of St. Louis.

Source: Courtesy of Federal Reserve Bank of St. Louis

Source: Courtesy of Federal Reserve Bank of St. Louis

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