Friday, April 30, 2010

Velocity as a source of growth


Blogging has been light this week since we took a quick trip to Palm Springs to watch the Palm Springs Follies—something everyone over the age of 55 should see at least once in their life. It's a celebration of how productive, healthy and happy you can be in your retirement years. The ages of cast members ranges from the mid 60s to 86!

Meanwhile, here's a quick look at M2 velocity updated with the latest stats on Q1 GDP growth. First quarter growth has been dissected by just about every analyst by now, but so far I haven't seen anyone looking at the behavior of velocity. On an annualized basis, M2 money fell by 1.5% in the first quarter, while nominal GDP rose by 4.1%; thus, M2 velocity (measured by dividing GDP by M2) rose by 5.7%. You might say, in other words, that rising money velocity was by far the dominant factor in the first quarter economic expansion. Rising money velocity is the flip side of falling money demand, and money demand is falling because confidence is on the rise. Money that was hoarded during the panic of late 2008 and early 2009 is now being spent again. The public is divesting itself of money that is no longer desired, and that has fueled an increase in general economic activity. As the chart suggests, this very important change on the margin is potentially still in its infancy.

This is exactly what the Fed has been trying to do for the past 18 months. First, the Fed had to massively increase the money available to economy (by flooding the banking system with reserves) in order to offset the economy's massive increase in the demand for money at the height of the panic. That served to halt the downward spiral early in 2009, and the economy then hit bottom in mid-2009. Since then, the Fed has continued to over-supply money to the economy by keeping short-term interest rates near zero, with the intention of encouraging a decline in the demand for money. Who wants money or cash equivalents (e.g., money market funds) when they pay zero interest?

We've now had over nine months of declining money demand (rising money velocity), and rising real and nominal GDP growth. By the looks of things (e.g., strong commodity prices, V-shaped recoveries in manufacturing and exports), it appears to me that this process is self-sustaining and that we should therefore see continued growth in the months and quarters to come. I see no reason to change my long-held forecast of 3-4% real growth.

UPDATE: As my friend David Gitlitz points out, the evidence of rising money velocity also reinforces my long-held concern that inflation is likely to rise.

Rationale in a nutshell: Inflation is a monetary phenomenon that occurs when the supply of money exceeds the demand for holding it. We know that the Fed has massively increased the supply of money, by 1) holding short-term rates at close to zero for the past 18 months, and 2) more than doubling the monetary base through massive purchases of mortgage-backed securities. Rising money velocity is the flip side of declining money demand, so rising M2 velocity reveals that the public's demand for money is declining. Supply is up, but demand is down, and the rising prices of sensitive assets such as gold and commodities would appear to confirm that we have an oversupply situation on our hands.

8 comments:

W.E. Heasley said...

Mr. Grannis:

Re: increase in velocity and penned up demand.

(1) going back to the recent increase in private passenger vehicle sales as related to the “scrap rate” of private passenger vehicles exceeding new production for the past 18 months or so (creating penned up demand),

(2) considering “cash” or cash equivalents on the side lines,

(3) considering de-leveleraging by firms and households (savings).

Obviously there a point where penned up demand, that forgone consumption (savings as related to de-leveraging rather than consumption), in relation to “cash”, adding in “scrap rate” in general, releases required consumption hence influencing velocity. For example, some capital goods can be substituted in the short run even if the capital good has become salvage. Within the realm of households, say a dish washer reaches salvage, one can merely wash dishes by hand as a substitute. If the leaf blower goes to salvage, one can use a broom.

The consumer can then use the labor intensive substitute to continue increasing cash and/or savings.

However the labor intensive substitute then competes with forgone “convenience” and or “efficiency”. This forgone convenience and/or efficiency then completes with “cash” and “savings”. Hence at some point the household finds the convenience and/or efficiency of greater value than cash and/or savings. The consumer then comes to a point where they reduce cash/savings to replace the capital.

Within this phenomena there is a difference between replaced capital, enhanced capital, and expanding capital. Does the consumer replace the dish washer with the lowest cost replacement? That is, the consumer seeks the lowest cost replacement that may be of a lower quality than the previous capital good as the consumer wants to have the least diminished savings in relation to the capital good or redirect the least amount of money from cash. Also, due to the consumer still valuing savings and/or cash, the consumer doesn’t add to capital. In other words, consumer X buys a dishwasher of lower quality than previous dish washer, spends $300 to replace a like kind quality dishwasher of value $500, saves $200 on consumption yet does not spend the $200 to increase the consumption of other capital goods.

Hence velocity increases, due to penned up demand, but the underlying dynamics of consumption leading to increased velocity are worth examination.

Benjamin said...

Good outlook. I hope for 4 percent growth, for several years. There is slack galore in this economy.

I can see interest rates near zero for a long time. You wanna buy Greek debt? Too much capital out there, not enough places to call home. US Treasuries are the parking spot of choice.


You might say, "Why save at zero?"

Two reasons: 1) If you are middle-class and planning retirement, you have no option but to accumulate savings, even at zero percent interest rates. If you put a potion of your portfolio into bonds, then you are depressing yields.

2 There are many institutional investors and high-net worth investors with large amounts of capita and income, much larger than they can consume. How many steaks a day can you eat? Even with two or three mansions, the million-dollar b-day parties, there are growing heaps of capital left over.

Look for safe yields to be near zero for years, and possibly negative.

I absolutely refuse to see Palm Spring Follies, as I absolutely refuse to acknowledge that any decimal system of numbers can apply even remotely to my putative age.

brodero said...

GDP/M2 times Nonfarm payrolls
bounced off its lowest low since
1994....throw job growth into
the increase in velocity ( velocity
was 1.86 before Lehman)and you have
growth.....

嘉偉 said...
This comment has been removed by a blog administrator.
John said...
This comment has been removed by a blog administrator.
John said...

Scott,

There is a big difference to me between 3 and 4 percent. I am afraid that consumer and government deleveraging might keep it at the low end of that range while increasing velocity and pent up demand could push it to the upper end or higher. Right now I am leaning toward the lower end - did not the first quarter come it around 3.2%? That is not going to get the unemployment rate down much. I know you don't like using unemployment as an inflation indicator but it sure looks to me like the fed is. I am still thinking the fed stays steady through at least November. 10yr treasuries are under 3.7% so the markets are still not looking for much inflation. Growth in our economy looks to stay modest and interest rates and inflation low....for now. After a brief correction the equity market should resume its process of discounting a slowly growing economy with low inflation.

Am I getting at least some of it right?

Benjamin said...

John-

I realize you asked for John's opinion and not mine, but I never let a detail like that stop me from sticking my nose in.

I think you are spot on. Ain't no inflation out there. Deflationary shock waves are still wending their way through the economy, including lower pay and rents. Worker productivity rising nicely.

Businesses in America now believe they have to be better every year. More productive every year. Everybody has got the religion.

BTW, some here have been lionizing the Swiss for the monetary rectitude, and how their strong currency makes them economically superior to us schlumpy Americans.

Well, go here and here:

http://www.indexmundi.com/united_states/gdp_per_capita_(ppp).html

http://www.indexmundi.com/switzerland/gdp_per_capita_(ppp).html


It seems that the USA has higher per capita GDP and has had higher GDP growth rates than Switzerland (over the last 30 years).

This, despite the fact we are a very polyglot nation with open borders, and carry most of the Free World's burden, in terms of gigantic military outlays.

I remain unconvinced about the arguments for a strong dollar. Still seems to me like a weak dollar would boost exports and US tourism, and encourage foreigners to buy US assets.

Scott Grannis said...

John: 3-4% growth is firmly in the "modest growth" range given how deep the recent recession was. Growth of that sort will not result in a significant or quick decline in the unemployment rate, and high unemployment will likely make the Fed reluctant to lower rates. But I do believe that 3-4% is stronger than the market and the Fed are expecting, so if this kind of growth persists, then the Fed is going to get very nervous and bond yields are not likely to stay below 4% for much longer.