The velocity of money is starting to rise

in busy •  6 months ago

The velocity of money (the rate at which money circulates) in the US economy is starting to rise. Take a look at the following graph:


The graph is produced by the St Louis Fed - here is the link, they have an interactive graph that allows you to hover your mouse over various points of the graph to get a numeric value:

Why is the velocity of money important?

Well, inflation is a function of the money supply and the velocity of money.

When the velocity of money started to collapse after the Great Financial Crash, the Federal Reserve started a program of Quantitative Easing, to increase the money supply, to offset the drop in the velocity. They did this to prevent deflation.

In the end they did about $3.4 trillion worth of QE. It was a success - the US didn't fall into deflation. And all the naysayers who thought that all that QE would cause inflation were proved wrong too - because they hadn't taken into account how fast the velocity was dropping.

Starting last October the Fed started Quantitative Tightening. That is, they are reversing the QE by taking money out of the economy by reducing the money supply.

Lots of commentators thought they made a mistake - but look at the chart, the velocity started to rise in Q4 2017. The Fed couldn't delay Quantitative Tightening any longer.

The Fed is removing $30bn from the money supply per month, and this will rise to $50bn per month in Q4 2018. And still inflation came in at 2.9%.

No wonder Jerome Powell is facing down the critics and carrying on with his program of raising interest rates and reducing the money supply. His goal is to do it smoothly - though there is always the risk that velocity will surge faster than he is tightening if Trump stimulates the economy some more. At which point he'll step up the pace of QT and a load of market participants will be caught off guard.

BTW - it's received wisdom that some of the QE money went into assets. If that is the case, the reversal of QE should see asset values drop. Perhaps the crash in Facebook shares was a harbinger.

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