Velocity of Money

I bought a toothbrush, some toothpaste
A flannel for my face
Pajamas, a hairbrush
New shoes and a case
I said to my reflection
Let's get out of this place
--Squeeze

Might the velocity of money become one of the more important metrics in upcoming periods? Conceptually, money velocity is the amount of economic activity associated with a particular money supply.

When velocity is high, much of the money supply is being used in transactions. When it is low, money is staying in wallets and bank accounts instead of being spent.

Money velocity is operationalized by taking GDP and dividing it by money supply. The chart below shows money velocity for the M2 measure of money supply. It is readily apparent that money velocity has been slowing down.

Many people view this as bad. The thinking is that if people aren't spending, then that is bad for the economy.

But money velocity has been declining since 1995. It has been declining in periods of reported economic expansions as well as contractions.

Let's think about what is going on here. Velocity can fall either by a decline in the numerator (GDP) or by an increase in the denominator (M2). GDP typically declines only during recessions, which doesn't fit the 15+ year trend. In fact, M2 related velocity currently sits at its lowest level in the last 50 years despite us currently being in a purported expansion.

What has been happening during this entire period is that M2 money supply has been expanding. Since 1995 is has roughly tripled. This has made the denominator larger and calculated money velocity smaller.

Moreover, because M2 does not include institutional deposits, money market funds, repos, and the like, the decline in money velocity due to expansion of the money supply is likely understated.

The takeaway is that massive quantities of money have been created over the past few years. When that money becomes employed in economic transactions, money velocity may not even have to turn up--it may just decline at a slower rate--in order to exert significant upward pressure on prices.

By then, it will be difficult to put the inflation toothpaste back in the tube.