Why Money Velocity Continues To Decline?

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Includes: DIA, GLD, IWM, QQQ, SPY
by: Disruptive Investor

Summary

Money velocity is at a 60-year low, but it does not necessarily imply very sluggish real economic activity.

Money velocity has declined due to as robust increase in M1 and M2 relative to the real GDP.

There is ample liquidity in the financial system as indicated by banks excess reserves with the Fed and asset classes will continue to move higher on liquidity support.

There is no doubt in my mind the real economic activity has stabilized to a large extent even when the economic might still need the support of Fed's expansionary policies to continue growing. A deeper look into the employment report (beyond the headline unemployment) provides some insights on the point that there might still be some spots of concern in the economy.

However, on an overall basis, the economy looks resilient and has recovered well from the worst financial crisis since the Great Depression of 1929.

Even with economic recovery, there are few indicators that are at multi-year lows. One of the economic indicators that I have closely followed in the past is the money velocity. I am of the view that the money velocity is a good indicator of real economic activity as investors need to look beyond the headline numbers published by the government.

The first chart below gives the velocity of M1 money stock and it is clear that velocity of M1 money stock is at its lowest level since 1975.

The second chart below gives the velocity of M2 money stock and it is clear that the velocity of M2 money stock is at its lowest level since the data was first recorded in 1959.

Before talking about the factors and reasons, the statement below come from the Federal Reserve Bank of St. Louis on the important of money velocity -

The velocity of money is the frequency at which one unit of currency is used to purchase domestically- produced goods and services within a given time period. In other words, it is the number of times one dollar is spent to buy goods and services per unit of time. If the velocity of money is increasing, then more transactions are occurring between individuals in an economy. The frequency of currency exchange can be used to determine the velocity of a given component of the money supply, providing some insight into whether consumers and businesses are saving or spending their money.

Given the above description, the general conclusion is that an increase in money velocity is indicative of a strong real economy and a decline in money velocity is an indication of a weak real economy where money is not changing hands at a robust pace.

However, the above statement and the charts would then imply that economic activity (as measured by M2) is weakest since 1959. This is certainly not the case and the reason is clear from the explanation below.

According to Investing Answers, the equation for GDP with money velocity is as follows -

GDP = Money Supply x Velocity of Money

In other words, the velocity of money would be GDP divided by the money supply.

In the above equation, if GDP growth is at a slower pace as compared to the money supply, the money velocity will decline even if GDP growth is stable.

The negative point here is that more of M1 and M2 are needed to fuel a smaller GDP growth while the positive point here is that the real economic activity is certainly not at levels indicated on first sight by the money velocity data.

To put things into perspective, the charts below provide the surge in M1 and M2 money stock after the financial crisis.

Both M1 and M2 have surged and this has translated into lower M1 and M2 money velocity even when the GDP growth has been robust in the recent past.

My point is further explained by the chart below that gives the excess reserves of depository institutions with the Fed.

In the last few years, the excess reserves of banks with the Fed have swelled and the conclusion is that banks have been conservative in difficult times. While the policymakers pursued expansionary monetary policies, the banks have been risk averse. Therefore, the liquidity flow into the real economy has been restricted by conservative banks. This links with the point that the growth in money supply does not reflect completely in terms of growth in economic activity.

Considering these points and charts, it is clear that the decline in money velocity is not directly related to "very low" economic activity. On the contrary, I believe that as confidence is restored in the economy, credit growth is likely to be robust and that will trigger further economic growth.

I would still remain cautious and watch for the impact of a potential interest rate hike on the liquidity and economic scenario. From an investment perspective, a high level of liquidity in the financial system is positive for equities (NYSEARCA:SPY). A strong liquidity in the financial system is also good for gold (NYSEARCA:GLD) considering a medium to long-term investment horizon.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.