The Velocity of Money
How it works.
The late and great Milton Friedman told us that inflation is always and everywhere a monetary phenomenon. But there is an asterisk to his equation that we need to examine. Namely, the velocity of money. Sometimes a fast-growing money supply is not as inflationary as you might think. In this report, we'll also take quick looks at why the banking sector is in for more and larger rounds of write-offs, as well as note that the housing industry is in a hole but is gamely digging itself deeper. This week's article will require you to put your thinking cap on as we travel to a mythical island to get an understanding of how the economy really works. So with no "but first," we jump right in.
When most of us think of the velocity of money, we think of how fast it goes through our hands. I know at the Mauldin household, with seven kids, it seems like something is always coming up. And with my oldest daughter Tiffani getting married this summer (forget gas, you haven't seen inflation until you start buying floral arrangements), more kids in school, "Dad, I need a car," high energy costs, etc., the velocity - at least in terms of how fast money seems to go out the door - seems faster than normal. And what about my business? Travel costs are way, way up, and as aggressive as we are on the budget, expenses seem to rise. About the only way to deal with it, as my old partner from the 1970's Don Moore used to say, is to make it up with "excess profits," whatever those are.
Is the Money Supply Growing or Not?
But I'm not talking about our personal budgetary woes, gentle reader. Today we tackle an economic concept called the velocity of money and how it affects the growth of the economy. But let's start with a few charts showing the recent and high growth in the money supply that many are alarmed about. The money supply is growing very slowly, alarmingly fast or just about right, depending upon which monetary measure you use.
First, let's look at the adjusted monetary base, or plain old cash plus bank reserves held at the Federal Reserve. That's the only part of the money supply the Fed has any real direct control of. It's not growing that much (less than 2%!), and a lot of the cash goes overseas, never to come back to the US. Also note that the growth in the monetary base has been trending down until recently.
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Next, let's look at MZM, or Money of Zero Maturity. Stated another way, you can think of it as cash, whether in a bank, a money market fund or in your hands.
Now, remember, Friedman taught us that inflation is a monetary phenomenon. If you increase the money supply too fast, you risk an unwanted rise in inflation. If the money supply shrinks or grows too slowly, you could see deflation develop.
Note that MZM is growing at close to an 18% rate year over year. Also note that less than three years ago MZM was growing close to zero. Since that time inflation has increased. Therefore, one could make the case that the Fed is causing inflation by allowing the money supply to increase too rapidly. Case closed.
Or maybe not. More cash sometimes means that people and businesses are taking less risk. The Fed cannot control what we do with our money, only how much bank reserves it allows and how much cash it puts into the system.
Forecasting inflation from a money supply graph is very difficult. It used to be a lot simpler, but in recent decades has been very unreliable for reasons we will look at in a moment. But it's much too simplistic to draw a direct comparison to inflation and an arbitrary money supply measure.
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If we look at a graph of M2, which includes time deposits, small certificates of deposit, etc. we again see a rise in recent growth. M2 is the measure of money supply that most economists use when they're thinking about inflation. And we see that M2 is growing at a sprightly 7% year over year. This is not all that high historically, but again it's up significantly over the past few years. See the graph below. Note there have been several times (as recently as 2000) when annual M2 growth was over 10%.
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I should note that M2 has been growing at 12% since the first of the year, so there is an acceleration in growth, which some find a major concern. If that pace were to continue, maybe we should worry, but M2 growth is quite erratic from quarter to quarter. In any event, there is another factor we need to consider besides the money supply.
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