Alternative analysis for informed middle market decision making
The velocity of money and recession
INSIGHT ARTICLE |
One long-held nostrum in economics is that inflation is always and everywhere a monetary phenomenon. For years, some economists focused on growth in the money supply and the velocity of money, which is traditionally defined as the ratio at which money changes hands, to ascertain the direction of growth and risks to the outlook from inflation.
However, over the past three decades, the velocity of money has generally declined as the Federal Reserve has imposed disinflationary policies, so the measure has fallen out of favor as a useful way to predict the direction of the economy.
Today, the broad and deep shock unleashed by the pandemic has caused the velocity of money, which I define as the price level times the number of transactions divided by the money stock, to decline to a modern low of 1.1.
The change in the velocity of money is generally a function of two things: the pace of growth in the economy and growth in the money supply. Despite strong growth in M2, a measure of U.S. money supply known as a money aggregate, the velocity of money has declined sharply.
This would tend to suggest that growth will remain quite slow once the initial rebound since the reopening of the economy passes. Moreover, despite the robust increase in fiscal and monetary policy to prevent a greater economic catastrophe, that risk to the outlook remains skewed toward disinflation or outright deflation in the near to medium term.
Readings of velocity at these levels also imply generous fiscal space and room for further unorthodox monetary policy by the Fed to address the current shock and in the post-pandemic economy. Time passes; things change.