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Velocity as a source of growth

Blogging has been light this week since we took a quick trip to Palm Springs to watch the Palm Springs Follies—something everyone over the age of 55 should see at least once in their life. It's a celebration of how productive, healthy and happy you can be in your retirement years. The ages of cast members ranges from the mid 60s to 86!

Meanwhile, here's a quick look at M2 velocity updated with the latest stats on Q1 GDP growth. First quarter growth has been dissected by just about every analyst by now, but so far I haven't seen anyone looking at the behavior of velocity. On an annualized basis, M2 money fell by 1.5% in the first quarter, while nominal GDP rose by 4.1%; thus, M2 velocity (measured by dividing GDP by M2) rose by 5.7%. You might say, in other words, that rising money velocity was by far the dominant factor in the first quarter economic expansion. Rising money velocity is the flip side of falling money demand, and money demand is falling because confidence is on the rise. Money that was hoarded during the panic of late 2008 and early 2009 is now being spent again. The public is divesting itself of money that is no longer desired, and that has fueled an increase in general economic activity. As the chart suggests, this very important change on the margin is potentially still in its infancy.

This is exactly what the Fed has been trying to do for the past 18 months. First, the Fed had to massively increase the money available to economy (by flooding the banking system with reserves) in order to offset the economy's massive increase in the demand for money at the height of the panic. That served to halt the downward spiral early in 2009, and the economy then hit bottom in mid-2009. Since then, the Fed has continued to over-supply money to the economy by keeping short-term interest rates near zero, with the intention of encouraging a decline in the demand for money. Who wants money or cash equivalents (e.g., money market funds) when they pay zero interest?

We've now had over nine months of declining money demand (rising money velocity), and rising real and nominal GDP growth. By the looks of things (e.g., strong commodity prices, V-shaped recoveries in manufacturing and exports), it appears to me that this process is self-sustaining and that we should therefore see continued growth in the months and quarters to come. I see no reason to change my long-held forecast of 3-4% real growth.

UPDATE: As my friend David Gitlitz points out, the evidence of rising money velocity also reinforces my long-held concern that inflation is likely to rise.

Rationale in a nutshell: Inflation is a monetary phenomenon that occurs when the supply of money exceeds the demand for holding it. We know that the Fed has massively increased the supply of money, by 1) holding short-term rates at close to zero for the past 18 months, and 2) more than doubling the monetary base through massive purchases of mortgage-backed securities. Rising money velocity is the flip side of declining money demand, so rising M2 velocity reveals that the public's demand for money is declining. Supply is up, but demand is down, and the rising prices of sensitive assets such as gold and commodities would appear to confirm that we have an oversupply situation on our hands.

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