Friday, January 29, 2010

Money velocity: the macro driver of GDP

I've read lots of commentary about what caused the larger-than-expected increase in GDP in the fourth quarter. Most observers note that the main driver of the 5.7% annualized growth rate was a decline in the pace of inventory liquidation, which contributed 3.4%. From this they conclude that the economy's strength was not that impressive, especially considering that the growth in personal consumption expenditures only contributed 1.4%. This may explain the market's weakness today.

I'm going to step above the fray and look at one of the macro sources of the growth in GDP. The one that immediately jumps out is the velocity of M2. (The inverse of velocity, i.e., the demand for money, is shown in the second chart above.) Money velocity rose in the fourth quarter at an annualized rate of 2.9% (and the demand for money fell by a similar amount). Some of the money that people had hoarded in the previous year (under the mattress, in money market accounts, or in bank deposits) was taken out and spent in the fourth quarter. This is the physical manifestation of a general rise in confidence; people came to realize that the precautionary money balances that they had built up were more than enough given all the signs of improvement in the economy. If this process were to continue until money demand returned to where it was pre-crisis, that would add a whopping 13% to GDP (assuming M2 doesn't decline in the interim).

One thing helping this process is the Fed. By keeping short-term interest rates close to zero, the Fed is trying desperately to convince people that they don't need all the money that they have been holding onto. It was the huge increase in the demand for money that prompted the Fed to expand its balance by purchasing $1 trillion of Treasuries and MBS; the Fed was simply reacting, as it should, to an unprecedented increase in the demand for money. As the demand for money declines further, the Fed will sooner or later be able to withdraw its injections of reserves into the banking system, and that needn't result in any major economic dislocations. What might happen, of course, is that the Fed may well decide to wait too long to reverse course, in which case we would end up with higher-than-expected inflation.

The other thing helping this process is the recovery itself. Note in the second chart that money demand usually tends to decline after a recession. Money demand rises in advance of and in the early stages of recession, reflecting rising fears and the demand for precautionary balances. It then declines as animal spirits return. This process was particularly intense in the recent recession, since it was mainly a financial-panic-induced recession. As the recovery progresses and confidence returns, the demand for money has plenty of room to decline (i.e., money velocity has plenty of room to rise), and this will be an important source of growth in nominal GDP in the years to come.

A final note: rising M2 velocity can actually do two things to GDP: it can increase nominal GDP and/or real GDP. So far it has mainly contributed to propel real GDP higher (since the GDP deflator has been less than 1% in the third and fourth quarters), but rising velocity could certainly contribute to a rise in the general price level at some point in the future.


Benjamin Cole said...

Week after week, I find the best economic analysis here at Calafia Beach, even when I disagree.

Why do I read when I disagree?

Well, it reminds of the lapsed Jew, who still went to Temple.

A fellow Temple goer finally asked him, "Moishe, why do you go to Temple if you no longer believe in G-d?"

And Moishe answered, "Well, just because I don't believe in G-d, doesn't mean there is no G-d."

Let's hope for robust growth in 2010, and I say even some inflation. We have to pay down our debts somehow, and inflation seems as good a way as any.

Bill said...


Do you think the January stock market returns predict how the rest of the year will go? (I saw one news item that says it generally is right 80% of the time)

Scott Grannis said...

Bill: I don't put much stock in technical analysis like. It didn't work last year, and why should it work this year? The fundamentals will always carry the day.

Unknown said...

"The Times quotes Zhu Min, deputy governor of the People’s Bank of China as saying that up to USD 1.5 Trn of USDs is being used to fund carry trade activity, particularly in emerging markets."
As I remember correctly you have mentioned that leverage is low in the markets. Above speaks a bit different view. I gues a hard data are difficult to get.

W.E. Heasley said...

Mr. Grannis:

Enjoyed the discussion of velocity and the demand for money.

Regarding velocity of money: have not heard a recent discussion of small transaction velocity vs. large transaction velocity. The velocity associated with transaction size and scope. Might be a good topic to discuss.

The original “megabuck”. Super velocity money. That makes for a good discussion.

Public Library said...
This comment has been removed by the author.
brodero said...

National accounts data provides a treasure trove of data but it suffers from something that is no fault of its own. Timeliness...
Quarterly representations often are too late and while velocity of money is fundamentally important I find it possesses a lag time in knowledge that renders it often ususable.If you know of some data that mirrors this but can be found
sooner please let me know.

Scott Grannis said...

Family Man: Regarding the suggestion that $1.5 trillion is being used to fund the carry trade:

Perhaps this refers to the fact that China's central bank has bought about this much worth of Treasuries. China has "recycled" its trade surplus back to the U.S. market by buying Treasuries. That recycled money can be used by us to fund all sorts of things. But it is mainly being used to fund Washington's income redistribution schemes, in my view.

Scott Grannis said...

WEH: Since I've used M2 for this measure of velocity, it is mainly focused on "small" transactions, since M2 includes mainly funds held by individuals, not institutions.

Scott Grannis said...

brodero: you make a good point about how GDP comes with a long lag. I think it's possible to track velocity with a shorter lag, by looking at weekly measures of M2 and currency. If they continue to grow at very slow (almost zero currently) rates while coincident measures of economic activity continue to reflect growth, then it's easy to assume that velocity is rising.

Unknown said...

On velocity, Paul Kaslier holds a view that it is going to be weak

Scott Grannis said...

Family Man: Kasriel has a bearish bias, and it shows up in his belief that velocity won't pick up. I'm the opposite. But I do believe that there is good reason to expect velocity to continue to rise, and thus to be optimistic. Currency growth is a good proxy for money demand, and it has been very weak--flat, in fact, for the past 4 months. Zero interest rates are a powerful incentive for money demand to weaken. The dollar, another proxy for money demand, remains very weak historically, though it has picked up just a bit in recent weeks. Consumer confidence is picking up, and I think that is a excellent sign that velocity will continue to rise.