Tuesday, September 15, 2009

Rising money velocity drives the economy

Here's another update to this chart. I show it because it illustrates a point I made in my previous post, about rising money velocity being an important source of economic growth. Rising money velocity is the flip side of falling money demand. When demand for the dollar falls, the dollar weakens unless the Fed takes steps to offset the decline in demand. That's the case today. Money demand is falling (because we know money velocity is rising), and the dollar is falling as well because the Fed remains extremely accommodative. As money gets spent instead of being stored under mattresses, economic activity picks up. It's "payback" for the surge in fear and trembling which tanked the global economy in late 2008. The economy is getting back on track, thanks to improving confidence and declining money demand. That's why the equity market is rising, because it realizes that the outlook for cash flows is improving.


The Lab-Rat said...

what does this chart look like over a longer period of time? if it doesnt fit over a longer time frame then whats changed? this isnt a loaded question btw but all too often people frame any chart to fit a story.

Scott Grannis said...

The relationship in this chart only holds from the beginning of last year, as shown in the chart. I would not expect it to hold over longer periods. For example, if the dollar were to weaken chronically over time, I would not expect equities to keep rising. What makes it work in the past year or so is the huge change in money demand and the degree of financial panic that drove the global economy into recession last year.

Blake Huber said...

hi Scott --

So if this relationship holds for the present time only, at what dollar level do you expect this relationship to break down between USD and equities? Ie, if the dollar sinks back to lows experienced in mid 2008 (dxy = 71 or 72), what deleterious effects would come into play that would negatively affect equities?

many thanks for your thoughtful comments,

Scott Grannis said...

Blake: excellent question, that's why I like to do this stuff because questions make me think.

At the rate things are going, there's little reason why the dollar can't fall to its prior lows or even lower. They aren't that far away, and with money demand falling and the Fed still easy and gold and commodities creeping higher, the path of least resistance for the dollar is lower.

I'm not sure what the level of the dollar is that causes everything to change. Prior lows (see the Fed's Real Broad Dollar Index, which has had a triple bottom about 5% below where we are today) might have to be broken in order for the Fed to wake up.

Once the Fed decides to pay attention to the dollar, instead of to the economy, then everything changes. Equities might drop initially as the Fed tightens, but over the long haul a Fed that gets back on track has to be good for the dollar and good for the economy and good for equities.

So, I would say that more dollar weakness and equity strength is in store. Then when things become very tense, because the dollar is plumbing new lows, the Fed will switch targets, equities will dip, but in the end the dollar and equities will head up.

The nightmare scenario for equities would be if the Fed just lets the dollar fall. Another 10-15% decline in the dollar with no Fed response would be a killer for the U.S. economy and the equity market.

Too much speculation, however, and it's too late at night to take this very seriously.

Blake Huber said...

Thanks so much for the explanation, Scott, makes a lot of sense to me. After looking back at the dollar-weighted basket (DXY), it looks like the overall trend in the last 4 months has averaged -1.2% a month. If we extrapolate at this rate, would take roughly until early March to get in the area of the lows reached mid 2008 - before the crisis (DXY < 72).

This may be drawing too much of a conclusion from just the recent dollar data, but I would say based on our discussion, the FED could be looking at raising rates as early as spring 2010 if defending the currency becomes necessary. If this proves to be true, it would be a much earlier time frame for rate hikes than I believe most economists are currently calling for (at least in the media).