A new generation of financial analysts are coming into the markets this year—and their lack of historical experience is worth considering.
If a university graduate is 22 and will be starting an entry-level analyst role at a bank or brokerage in 2018, that person was 11 when the Global Financial Crisis began. That person was also 16 or 17 during the height of the Fed’s QE measures of this decade. Their understanding of the biggest concerns of monetary policy and money supply may be more theoretical than based in real-world experience.
At the height of the post-crisis desperate measures from the Fed, libertarian and freshwater economists rang alarm bells about the higher inflation that a rapid increase in the money supply (effectively what QE is) would cause. Nearly a decade after the first round of QE, and inflation has remained stubbornly low.
The primary reason for this goes back to an old economics theory from 1911. Penned by Irving Fisher, the theory related to how demand in the marketplace is reflected in prices, and how a decline in demand can be observable in the way money is used.
The theory, expressed mathematically, is this:
MV = PT
Where m = the total nominal amount of available money supply (i.e., the total amount of currency available in all accounts in an economy, unadjusted for inflation);
V = the velocity of money (i.e., how frequently is money used to buy goods and services in an economy)
P = the price level (i.e., the cost of a hypothetical basket of goods and services—the price level is expected to vary but the basket should remain constant for measuring purposes)
T = an index of inflation-adjusted value of all transactions in aggregate.
The idea here is that prices rise not only with an increase in the money supply (M) in the equation, but also with an increase in the frequency with which money is used (V). Intuitively, this makes sense; if people have more and more money but aren’t actually using it, sellers have little opportunity to increase prices without negatively affecting the demand curve.
Lower velocity, then, is deflationary, which is why the Federal Reserve focused so much on increasing the velocity of money during the post-2009 recovery years. Unfortunately, they failed.
The Fed’s measurement of M1 money stock was near 11 before the 2007-2009 crisis began; it’s now 5.49. That 5.49 reading is also 2.9% lower than it was a year ago. Money velocity declines have not stopped since 2008.
The reason why this is so is controversial. Some argue QE was a failure, because banks received an influx of liquidity but didn’t pass that liquidity on to individuals and corporations. From this perspective, increasing money velocity will not be possible until credit quality standards are relaxed—something regulators, bankers, politicians, and even many individuals are nervous about doing after the subprime disaster of the 2000’s.
Others argue that money velocity increases will be impossible in the “new normal” economy where there are few investment opportunities for firms. This lowers capital expenditure, which is a larger contributor to money velocity. From this perspective, the Fed cannot improve money velocity on its own, and we would need to see a truly revolutionary change—something like a universal basic income or extreme tax cuts that incentivized spending, and thus more transactions and a faster money velocity.
The latter, of course, became a reality at the end of 2017, when Trump’s tax cuts went into effect. Data for money velocity has not been released for the first quarter of 2018, so it remains to be seen whether that tax cut actually resulted in higher money velocity. But since velocity will result in higher prices, we could theoretically see the velocity coming back in the form of inflation.
The Fed’s preferred inflation measurement, Personal Consumption Expenditures (PCE), is released monthly, so we can see if inflation is visible there. And PCE ranked at $13.78 trillion in February 2018, up 4.7% from a year ago. In February 2017, the $13.18 trillion PCE was… 4.7% above the prior year.
If we look at the more commonly used inflation measurement—the consumer price index (CPI), seasonally adjusted—we see inflation rose 2.3% in February 2018 year-over-year, which was lower than the 2.8% we saw in February 2017 on a year-over-year basis. So both PCE and CPI indicators suggest that, at least for now, inflation momentum hasn’t increased—which would indicate that the falling money velocity metric is probably not getting better.
Macro analysts will need to understand what is going on here, especially because we are in a rate tightening cycle. To understand whether the Fed’s, the market’s, and individual investors’ expectations for higher interest rates and economic growth are an accurate reflection of reality, they need to think a lot about what’s happening to money velocity, even if the idea is nowhere near as trendy to study as it was during QE days. Unfashionable as it may be, as a tool to understand what’s happening in the economy, it’s as important as ever.