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Velocity of Money

March 29, 2021
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In this weekly post, we have repeatedly discussed our concerns about our Federal Reserve buying assets in the open market (mostly bonds) and keeping interest rates artificially low for years now. Historically low interest rates have empowered the Federal government to take on enormous amounts of debt (now totaling nearly $30 trillion) and spend money recklessly.  Now, with the worst of the Covid crisis clearly behind us, yet monetary and fiscal “stimulus” going full tilt (supposedly another $3 trillion “stimulus” waiting in the wings,) Americans are bracing for the strongest inflation in a decade as the new “stimulus” promises to accelerate the U.S. economic rebound. Consumers' median year-ahead inflation expectations rose to 3.1% in February from 3%, according to the Federal Reserve. Expectations for inflation three years from now held steady at 3%, according to the Fed.

Intuitively this money circus will not end well, but the discussion of the looming inflation because of the financial profligacy of the Fed and Congress seems to be overblown right now (many are discussing drastically higher inflation numbers than are listed above.) We are the first to discuss potential consequences of financial leaders who lack any modicum of discipline. However today, we want to introduce to you another variable in this complex monetary equation that will at least shed some light on the recent performance of our economy where the “pending rocket launch” of inflation has only reared its ugly head in a few industries.  This is leaving a lot of pundits scratching their heads and wondering when this imminent total paper-money meltdown occurs. We can’t answer that question, but we can continually add variables and factors involved in the situation to help us find cracks in the dam as they occur...

Enter the Velocity of Money – also loosely defined as the money multiplier. This is a fairly simple economic concept, yet we find it very rarely discussed – especially by those telling you about an imminent doom in our monetary system.  Here is the definition according to Investopedia:

The velocity of money is a measurement of the rate at which money is exchanged in an economy. It is the number of times that money moves from one entity to another. It also refers to how much a unit of currency is used in a given period of time. Simply put, it's the rate at which consumers and businesses in an economy collectively spend money. The velocity of money is usually measured as a ratio of gross domestic product (GDP) to a country's M1 or M2 money supply.

To further illustrate this concept, imagine that you borrow $30,000 for a new car. That money is conjured into existence by our banking system. You spend it on the car. The car company uses that money to pay its material costs, employees, other operational costs, taxes, etc.  The car company’s employees then take some of that money and go out to dinner. The waiter from the restaurant takes some of the tip money and goes to buy gas for his car to get him home. The gas station then… and so on and so forth…

How many times the same dollars are spent is a very important factor in how quickly inflation takes off. Well, take a look at the history of the velocity of M1 (very liquid, usable monies) historically…

Of course, the velocity of money is not the only variable in what drives inflation. As an example, the government reported inflation was DRASTICALLY higher in the late seventies and early eighties than in the 2007-08 period. Yet from this chart the multiplier was much higher in the same 2007-08 time frame than the seventies/eighties. Obviously, many other factors are involved…

However, the point of this discussion is to show you how the velocity of money has completely fallen apart. Of course, the Covid has a lot to do with this, but even before covid hit these numbers were down near 50-year lows. Now with the “stimulus,” we will see how these numbers react. This is very interesting regardless of the Covid considering the lack of discipline on the part of monetary/fiscal authorities. The money isn’t changing hands very many times. Has the methodology for calculating these numbers changed? Has the more widespread use of credit put a damper on the multiplier over the years? One thing that these numbers do seem to imply is that the percentage of money being created is going into hoarding (asset prices going higher for the uber-rich.) Also, some of the money may be sent overseas for the purchase of foreign made goods.  That wouldn’t make these velocity numbers – but still should be considered because down the road some of that money may come back to the U.S. chasing the same goods, services and asset prices we are trying to buy. That would reignite inflation.

Inflation is off the charts on asset prices (have you tried to buy a house lately?)  However, in everyday purchases, runaway inflation just hasn’t hit to the degree that you would expect considering the trillions of $$ being poured on the game. We are not suggesting that inflation isn’t coming down the road, however we are looking for reasons that it hasn’t hit already. Looking at the velocity of money implies that a lot of the “stimulus” is just being gathered up right now rather than spent in the open economy.  There is slack in the system from Covid that may be getting filled up very quickly by government actions. We will keep searching for the cracks in the dam, but right now the imminent doom of the value of our currency seems overblown to us. Stay tuned…

Regards and good investing,

Greyson Geiler