Friday, June 19, 2009
This chart is a followup to an earlier post, whose point was the velocity of M2 is probably close to beginning to turn up. The slowdown in M2 growth we have seen in recent months is most likely an indicator of that very phenomenon. Money velocity is the inverse of money demand, so a decline in money demand shows up as an increase in velocity. It has long been my belief that M2 is a much better indicator of money demand than it is of money supply. The best measure of money supply would be the monetary base, which is composed of bank reserves and currencies, and those are directly controlled by the Fed. So slowing M2 growth is a good indicator of declining money demand.
As this chart shows, money growth (i.e., money demand) typically reaches a peak in the wake of recessions. That's because people's risk aversion declines dramatically in recessions, and since most recessions have been the by-product of tight money, money demand is in part driven by a desire to deleverage. Money growth rises as people accumulate cash and pay down debt, and the Fed accommodates this increase demand for money by reducing interest rates. Then, when conditions start to improve, the opposite happens, and people start to want less and less money and more debt. The M2 that was stored up during the recession is unleashed and spent, and that is one of the things that powers the subsequent recovery.
In the three months ended June 8th, the annualized growth rate of M2 fell to 2.3%. If nominal GDP growth in the current quarter is 1.7% (I'm assuming growth of -0.8% and inflation of 2.5%), then velocity will be only modestly lower than it was in the first quarter. If the slowdown in M2 continues and the economy starts to recover, it will be because M2 velocity is starting to pick up. In short, there's an M2 mountain of cash out there that could power the economy for the foreseeable future.
Posted by Scott Grannis at 12:10 PM