It's The Velocity, Mr. Chairman, And It Stinks!

Includes: DIA, QQQ, SPY
by: Josh Krause

With his recent decision to blow out the all of the stops and go for the nuclear option of unlimited QE and ZIRP forever as the stated policy of the Federal Reserve, it is obvious that Chairman Bernanke believes in what he is doing. While I may disagree with his methods and believe that his approach to QE cannot achieve his stated goal of increasing employment, he is operating with a limited playbook and receiving no assistance from his fellow teammates in Congress.

A Look Back

For the last four years, the Fed has been expanding its balance sheet in an attempt to offset the private sector deleveraging from the recent credit crisis. In this time, we have heard many calls for imminent hyperinflation due to the printing presses being turned to quantum speed. Other than a gradual trend higher in the cost of everyday consumables and a leak higher in oil costs, we are well below what anyone would call crisis levels of inflation, bordering on imminent "Weimarzimbawbeism" (The state of infinite money printing and instant billionaires).

(click images to enlarge)

Fed Balance SheetClick to enlarge

Source: Federal Reserve

Even after tripling the Fed balance sheet from $800 Billion to $2+ Trillion, we are only now breaching the 2% inflation target set by the FOMC. Since we are just a few days after the recent confirmation of QE while also experiencing significant drought and Mid East turmoil, it may be premature to think that the current inflation spike will be worsened by the new measures. After QE1, QE2, Operation Twist 2.0 and Twist 2.0+, we saw an initial spike in inflation as people rushed for hard assets, and then a gradual downturn as private sector deleveraging overtook the increased demand.

The fact that more money is being printed is well covered, and oft used as the straw that will break the camel's back and send us into serious inflation. The only problem is Bernanke has been printing money for years now, but has proven to be completely unable to affect one of the main measures economic growth and activity -- the velocity of money in the system.

Economic Speedometer

If one were to believe that an increased money supply was enough to spur economic growth or trigger massive inflation, the following graph would have you believe that we are either going hyperbolic and under the effects of Weimarzimbawbeism, or that we're entering a golden age:

Chart of Money SupplyClick to enlarge

While the graph tracks well with the expansion of the Fed balance sheet, comparing it to economic growth in the country does not track well, and versus the velocity of money in the system, comparisons break down very quickly:

Chart of Money VelocityClick to enlarge

Starting with the recession in 2008, you can see that the velocity of money in the system has been falling, with only temporary reprieves. There was a dead cat bounce after the market rebounded in 2009, but as time has passed, the velocity of money in the system has continued lower to levels not seen since the inception of the data series.

Why is the velocity of money important? Well, since it serves as a measure of the economic activity of the money supply, it is very telling that even with record high amounts of dollars in the world, each one is seeing less and less use in the domestic economy. Going by the data available, we can see that while Bernanke can stuff as many dollars as he can down the gullet of the system, he can't force them to be used within the economy.

QE for Dummies

Quantitative Easing essentially pours money into the banks, who then take their share and then use the rest as they see fit. If the bank believes speculation in commodities or equities will bring a greater return than initiating new loans, then that is what they are going to do. The Fed has, or chooses to exhibit, no control over its member banks. Those that already hold large amounts of hard assets and equities (the wealthy) benefit from the increased risk appetite and, if Bernanke is to be believed, go out and spend.

Since most of the equities owned by the middle class are locked up in 401(k)s that exact stiff penalties for early withdrawal, and many wealthy individuals secure their investments in trusts and other such protected constructs, hopefully the Chairman understands that any attempts to goose the stock market will lead to extremely marginal returns with regard to economic activity. People are not going to liquidate their portfolios to buy a new vacation home, especially if the market is screaming to new highs and they may miss out on fully recovering from the two collapses we saw in the last decade.

Even with the fact that liquidating equity positions is a rare activity for most, we have an entire generation preparing for retirement that is seeking safety and looking to lock up as much income as they can to live comfortably in the future. Combine that with constant cries to buy hard assets in the form of gold, silver and other commodities, and we are seeing large sums of money going away from investment and speculation. The trend with QE has been outsized rewards for those that already own assets -- the wealthy.

Wealthy Grows Wealthier

Rich people have low money velocity.

There, I said it. The more money that rich and wealthy people have, the lower the level of economic activity we see in the money supply. It's not that they hoard it or don't deserve the money they have. It's that they simply don't spend as much of it as those who are not as well off. For many, that is how they became wealthy.

To obtain wealth, you have to retain your money. It's a pretty simple concept. Either through equities, gold, property or direct investment, you have to be successful in taking your money and locking it up to hopefully gain a return. Since that money is effectively removed from the system of economic activity while you wait to collect on your investment, the larger the portion of your income and asset base retained in this way is, the lower your contribution to money velocity.

The more that a person spends as a percentage of their income, the higher their contribution to the velocity of money in the system. Middle and lower income earners spend a far larger portion of their income than the wealthy, and as such, you tend to see increasing and higher levels of money velocity when those segments of the marketplace receive larger portions of the pie. Though there is some volatility, we can see a gradual increase in money velocity through the timeline of available data. Correspondingly, throughout this period, we saw the household incomes of the middle class increase over time, with economic activity able to sustain a significantly positive trend. The phrase "a rising tide lifts all boats" takes on new meaning when you think of it as starting from the bottom up and not the top down, as so many adhere to.

While much of the income gains seen since 1980 were fueled by taking on an ever increasing amounts of debt by middle income earners, we continued to see increased levels of economic activity and money velocity for as long as the middle class enjoyed an increasing portion of the income pie.

Changes In The Trend

Over time, the growth of middle income earnings has moderated, and in the case of many middle class families, reversed. A census bureau study of the share of income from 1967 to 2011 shows that the top 20% of earners have gone from holding 44% of the total income to over 51%.

Income Distribution Since 1967

If money is increasingly going to those who are already wealthy, it should not be surprising that we are seeing an ever collapsing velocity and struggling to maintain a positive trend in economic activity. While Bernanke doesn't typically cover the velocity of money in his speeches, I believe he would be hard pressed to identify how his policies are going to benefit this measure due to the very nature of quantitative easing.

Increasing Economic Activity

The results we have seen through the two previous rounds of QE will likely repeat. The vast majority of income gains will be seen by the already wealthy, who already hold the hard assets, and the income gap will grow wider. New highs will be seen in the major indexes (SPY, QQQ, DIA). Economic activity and the velocity of money will continue to stagnate as by their nature, the wealthy are very effective at removing money from the system and will be receiving a larger and larger portion of income growth.

I don't mean to blame the wealthy for this -- far from it. It's more of an observation of what the impact will be from this newest round of easing, and comes from a desire for solutions that will actually increase the velocity of money and foster economic activity.

Chairman Bernanke has charted a perilous course with these most recent announcements, and while I don't yet think we are headed into the waters of Weimerzimbawbe, I do strongly question his belief that increasing the wealth effect by boosting stocks will result in an increase in economic activity and a recovery in the velocity of money.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.