What the Slowdown in Money Velocity Could Mean

OK, it is time to put on your “economic geek” hat.  The velocity of money is the rate which money is exchanged from one transaction to another and how much a given unit of currency is used in a given period of time.  Money velocity is usually measured as a ratio of Gross National Product (GNP) to a country’s total money supply.  This concept helps tell how healthy the economy is, and it is also a key input in determining inflation in the economy.  A country with a higher money velocity compared to another tends to be further along in the business cycle and should have a higher rate of inflation.

As an example, this morning I dropped off my son’s car to be serviced.  When I pick it up later today I will pay for the work completed.  If that is the only place where the money goes within a given period of time, and the shop owner puts it in his savings account, it would have a velocity of one.

Now say the shop owner takes the money and goes to the store to buy groceries.  The grocer then spends that money on wages for a clerk and the clerk pays his rent.  In this case the money velocity has risen to 4.  When an economy is healthy, lots of buying and selling exists and money moves quickly.  Unfortunately, the US economy is in the exact opposite state right now and indicates we may enter into a deflationary state even though the Federal Reserve has been turning on the faucet by flooding the system with more money.  Some will argue this is creating a financial bubble, like the dot.com and housing market bubbles we have seen since the turn of this century.

When you look at the velocity of money supply as defined by M1, you will see that velocity declines during a recession, as you can tell with the shaded areas of the chart below.  Now M1 is includes all physical money, demand deposits, and NOW accounts.  The odd circumstance is that M1 has continued to fall since the last recession and is now at a near 20 year low.

Even if you look at the M2 money supply, the news is not good.  M2 includes all of M1 plus savings deposits, money market mutual funds, and other time deposits.  The velocity of M2 has now dropped to the lowest level ever recorded.

According to the velocity of money indicators, we should be in the throes of a recession.  In some ways we are.  Even though the unemployment rate is low, a record number of Americans are now out of the work force.  The labor force participation rate is the lowest it has been since the Carter years.  One in 8 men in their working years of 25-54 are not in the labor force at all.   This ratio is at an all-time high since records were kept in 1955.  An additional 2.9 million men are classified as unemployed and in the labor force calculation.  This leaves a total of 10.2 million men not employed out of a census of 61.1 million American men in the work-force, which equates into a 16.7% unemployment rate for men.  It is not a pretty picture for women workers as well.

As the Fed meets this week, everyone is questioning if they will raise interest rates.  Though one can never guess what the Fed will do, there seem to be enough economic headwinds here and also in other foreign countries which are experiencing economic recessions and slowing growth, for no increase in rates.

We will just have to see if the slowdown of money velocity is another predictor of a recession and deflation.