Velocity of Money Explained
As the Federal Reserve Bank (Fed) begins to transition from 6 years of unprecedented monetary policy we are at an inflection point for money supply and velocity of money. While the Fed focuses on controlling short-term interest rates via the Federal Funds rate, now at .25%, the goal of increasing interest rates from here is to reduce the money supply. Since the money supply is inversely related to velocity, we will expect velocity to rise as money supply falls; assuming the economy strengthens of course.
The velocity of money, as measured by M2 money stock, has been in a free fall since 2008 and is now at historic lows of 1.53. This is closely associated with the great recession and the Fed's QE policy which added $3.5 trillion to the Fed's balance sheet.
Velocity of Money, M2 Money Stock (1959-2014) (Source: St. Louis Federal Reserve Bank
There is increasing talk surrounding the Fed's timing for the first rate hike in more than 8 years and the lowering of the M2 target. So, what is the relationship between money supply and velocity? How important is this coming Fed action?
Velocity is the number of times per year that a dollar is spent in buying the total amount of goods and services produced in the economy. From 1945 to the early 1980's velocity was relatively stable and predictable. Beginning in the late 1980's velocity has become unstable after a sharp rise and a steep fall to record lows. From the late 1990's through today the fall in velocity can largely be attributed to the rise of the internet and institutional changes that have altered the ways individuals conduct transactions resulting in using money less often. While theory suggest velocity should rise under that scenario, since 2008 real economic weakness has dominated and complicated the Fed's theory of exchange with respect to money supply and income.
Velocity (V) is defined as total spending divided by the quantity of money (M2). Where total spending is the price level (P) times total output (Y), and PY equals nominal gross domestic product (GDP).
V = PY/M
Velocity is inversely related to the money supply, so that as velocity rises the money supply falls. This is the basis of the Fed's decision to change the direction of monetary policy in December 2015. Additionally, velocity is linked to the money supply by the demand for money which is in turn affected by the level of interest rates. As interest rates rise (fall) individuals hold smaller (larger) money balances so that velocity rises (falls). Herein lies the problem. Changes in the level of interest rates no longer possess the same magnitude of influence over demand for real money balances thanks to rapid and continued financial innovations. That is to say that the Fed has lost a certain degree of control it once had in their ability to implement monetary policy.
The Fed determines the level of money supply to the economy based on its expectations for the levels of demand for money in the economy. Such that, the money supply (MS) is equal to money demand (MD)
MS = MD
So, it is the ability of the Fed to accurately predict money demand that determines their ability to hit their money supply target.
The Fed cannot control the money supply and interest rates at the same time. If they attempt to control the money supply than the economy will experience volatility in interest rates. If on the other hand the Fed controls interest rates (which is does today) than the economy will experience volatility in the monetary aggregates. The two and a half year experiment in controlling the money supply conducted by Fed Chairman Paul Volcker from 1981-83 resulted in wild swings in interest rates.
By controlling short-term interest rates the Fed indirectly influences the money supply and nominal GDP through the effects interest rates have on demand for money.
Given the Fed targets interest rates, as they begin their tightening cycle the market should expect relatively volatile money supply data and some difficulty for the Fed in setting and hitting monetary targets. Keep in mind in the early 1980's the Fed was mandated by Congress to release targets for growth in the monetary aggregates like M2.
When will the Fed hike rates? As soon as possible. The risk of keeping rates near zero is growing and can be argued is greater than the risk of hiking rates a few months too early. It is become more likely the Fed hikes rates in the 3rd quarter and begins to turn the screws on the economy. Coming off of such low levels it is unlikely the first 100bps hike in rates would be a drag on an already soft economy. After all, it has long been said it is the Fed's job to take the punch bowl away just as the party gets going. While slack does exist in the economy, particularly in the labor market, the Fed will surely be watching for renewed inflationary pressures by the second half of the year as the recovery continues.