What Does The Velocity Of Money Mean For The U.S. Inflation?

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by: Oleh Kombaiev

Summary

Velocity of money in the United States reached record small values.

Decrease in the velocity of money ensured low inflation in the United States amid rising monetary base.

The FRS’s focus on tightening the monetary policy will lead to the increase in the velocity of money, accelerating the inflation.

It is hard to overestimate how much the inflation now means for the market of stocks, bonds and commodities. And primarily because the FRS aligns its monetary policy with this indicator. In the context of the U.S. inflation prospects, I would like to draw your attention to such macroeconomic parameter as the velocity of money.

A little theory. Quantity Theory of Money is based on the following fundamental equation:

MV = PQ

  • M - money supply;
  • V - velocity of money (or the rate at which people or/and companies spend money);
  • P - general price level;
  • Q - volume of transactions of goods and services;

This equation can be transformed as follows:

PQ = MV = GDP (nominal)

or

V = GDP / M

or

GDP = V * M

So, as you can see, with a stable monetary supply the level of the nominal GDP is proportional to the velocity of money. In other words, increase in the velocity of money leads to higher inflation and nominal GDP.

All other things being equal, the velocity of money in the modern world should have an upward trend, since the widespread use of credit cards and online payments makes it possible to carry out economic transactions faster. In practice, the velocity of money in the United States has been steadily declining since 2008, reaching a record low in Q4 2016. Accordingly, this phenomenon hinders the growth of inflation.

The most likely explanation for this situation is the duality of the demand for money. The money is primarily required by people and companies for transactions - the so-called "active money." Money is also used for savings and accumulation - the so-called "idle money." The more "idle" money there is in the economy, the lower the velocity of money is.

As a measure to overcome the financial collapse of 2008, the FRS of the United States resorted to the solution, now well known as quantitative easing. As a result, the monetary base increased by more than 350% from 2008 to 2014, while the interest rate fell to virtually zero.

The decrease in the interest rates resulted in that it became less expensive to own money with a view to saving; and, as a result, the amount of money with zero circulation speed ("idle money") grew.

For the same reason, corporations have amassed a huge amount of money in their accounts:

AAPL Cash and Equivalents (Quarterly) Chart

So, as of today, the United States has a record supply of money and record-low velocity of money. Based on the formula in the beginning of the post, this situation means that even a slight increase in the velocity of money can have a significant effect on the growth of the nominal GDP. And, in my opinion, such a situation could occur in the near future.

Having raised the discount rate twice from 2015, the FRS intends to do another three raises in the current year. The FRS has clearly taken a course on tightening the monetary policy. And now the demand for money as a means of saving and accumulation should start to decline, increasing the velocity of money and, therefore, the inflation. In addition, assuming that Trump fulfills at least part of his protectionist promises amid the economy close to full employment, it will feed the inflation even more. As a result, this will lead to an increase in interest rates, and 10-year bond yield in the United States may well jump to 3.5% and even a lot higher this year.

I previously showed what the increase in the interest rates means, for example, for the gold market. This will have an enormous effect on other markets and the global economy as a whole. Apparently, the period of extremely cheap money has ended. The new era is ahead and we should get ready for it.

Disclosure: I/we 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.

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