Friday, October 29, 2010

M2 velocity suggests a stronger Q4 GDP

I'm going to leave it to others to tear apart the Q3 GDP number (which was a bit disappointing) and focus instead on where GDP is headed, from a top-down perspective. Quarterly GDP numbers aren't very useful, in any event, since they are old news by the time the first estimate comes out, and then they are subject to multiple revisions. The point of paying attention to the economy is to know where it's likely to go in the future, not where it's been.

Let's start with money. The M2 measure of money is arguably the best (and it's my long-time favorite): it is published weekly with only a minor lag, it's subject to only minor revisions, its definition hasn't changed materially over the years, and it's displayed the most stable relationship to nominal GDP over long periods of any measure of money.

This first chart shows M2 velocity, which is nominal GDP divided by M2. The inverse of this measure is money demand: how much of a year's spending the economy wants to hold, on average, in the form of currency, checking accounts, retail money market funds, small time deposits, and savings deposits. Note that, as the chart above shows, for the past 50 years M2 velocity has been virtually unchanged on balance, though it has oscillated up and down in the intervening years.

The big story behind the economy's collapse in 2008 was a huge surge in money demand (i.e., a huge decline in money velocity). People thought the end of the world was approaching, and so they stopped spending and started hoarding cash; the demand for money surged, and money velocity collapsed. The velocity of M2 fell almost 13% from the end of 2007 through mid-2009, the largest decline in velocity on record. This process has been partially reversed since the economy started growing in mid-2009, as M2 velocity has risen 1.9%. Confidence is slowly returning, and people are beginning to un-hoard some of their cash. Nevertheless, the revival of M2 velocity is still in its infancy.

M2 velocity only fell modestly in Q3/10, as nominal GDP grew at a 4.4% annualized rate and M2 grew at a 5.0% annualized rate. I suspect that it will be trending higher over the next several quarters as confidence continues to build, but let's assume that velocity is unchanged in the current quarter. With M2 currently growing at a 7% annualized rate over the past six months, and at a 8% rate over the past 3 months, we could reasonably expect M2 to rise at least 6% (annualized) in the current quarter. If it does, and velocity remains stable, that would imply a 6% nominal rate of growth for GDP in Q4/10. Of course, if velocity picks up, then nominal GDP could grow even more. Furthermore, if inflation in the current quarter remains at the 2% pace of Q3, then we could see real GDP growth in Q4/10 of 4% or more.

As one commenter mentioned earlier today, we would need to see at least 4.5% real growth in the fourth quarter in order for real growth to equal or exceed 3% for all of 2010. I don't think that's unrealistic at all. I know there are a lot of assumptions behind this forecast, but I don't think I've made any that are unreasonable, so I'm sticking with my call for 3-4% growth for the current year and for the average of the next several quarters. If I'm wrong it won't be by much. And given the market's penchant for seeing a double-dip recession around every corner, even if growth this year comes in at 2.5% that will be more than what I think the market expected to see.

In this last chart I've plotted the level of real GDP against a 3% trend. This gives us a proxy for what the so-called "output gap" might be, which I estimate to be about 7-8%. Growth has to exceed 3% for the output gap to close, and until it begins closing we are unlikely to see any meaningful reduction in the unemployment rate.

I think it's possible for growth to exceed 3%, especially in the wake of next week's elections. I firmly believe the elections will have a powerful influence on the course of fiscal policy, since they will send a clear mandate to Washington to a) slow the growth of government, b) roll back ObamaCare, c) keep cap-and-trade on hold, and d) extend the Bush tax cuts. This will result in a much-needed business confidence boost, which in turn should unleash at least a mini-surge in new investment and new jobs, not to mention a boost to M2 velocity.

If there is a dark cloud in this otherwise bright forecast, it is that inflation pressures are likely to gradually build, since the Fed—with its Phillips Curve/output gap mentality—is likely to be slow to respond to signs of an improving economy. But inflation concerns will be relegated to second place for at least awhile, while markets breath a sigh of relief.


septizoniom said...

here is an example of where you are blinkered. cut it out. it's trite now.

mmanagedaccounts said...

Since imports surged at a rate of 17.4%, subtracting from a 2.6% real rate of growth in consumer spending and a 9.8% increase in business investment, it has been suggested that corporations are moving production overseas. Why? It is because of increased concerns over increased regulations and increased taxes, and increased costs of healthcare insurance. Corporations have over $1 Trillion sitting idle. Were management confident in business and consumer consumption, that money would be put to productive use.

I know it sounds simplistic, but lower taxes and less regulation could unleash a surge of economic activity that may reverse last quarter's surge of imports.

marmico said...

What's the r*2 on the chart Grannis? It's not of any significance, is it?

It is arguable that Q4 GDP will be negative. That's my position. I will concede ceteris paribus for consumption, investment (ex-inventory), government and net exports quarter over quarter.

Now my position is that there will be a decline in build in inventory. All it will take is ~ $25 billion (Q3 was a build of $47 billion).

Here is some guy bitching about government, yet the feds added 70 out of 200 basis points towards GDP contribution. Give your head a shake man.

Tick, tock.

I'll make another prediction. Real per capita GDP in Q42012 will be lower than real capita per GDP in Q42007. Oh, and with all the hubris I can muster, I won't be very far off.

Don Halldin said...

Where do you teach? Let me guess...the Krugman center of Economic Nonsense and Rudeness at the University of Dismal Leftists? NYC campus? Do you stand with the 1.75 multiplier on food stamps that Madam Pelosi promotes? How about cash for clunkers? Government workers unions? Teachers unions? Command economies? Income redistribution? Cry Babies?

If on the other hand you had ever had to actually balance a payroll checkbook,employ anyone, or produces anything others would consider of value by say purchasing it from you you may have a different view as to the appropriate roll of government

Should your precious government stand down, restore some semblance of free markets and economic freedom to the poor helpless morons that are the American people perhaps we will "WORK" our way out of this mess.

McKibbinUSA said...

Hi Don, the truth is that neither the Republicans nor the Democrats have a plan that "fix" the challenges confronted by the US economy -- sorry for the bad news...

Don Halldin said...

Hello Dr,
Good to hear from you. I agree that the two political parties do not offer "plans" that will alleviate the problems we face.

My belief is that only by having no plan can we possibly succeed. Tom Friedman's view not withstanding

Freedom creates all kinds of unpleasant outcomes for those unwilling to compete through educating themselves, diligently working to better their conditions and constantly striving towards a worthwhile objective. For those capitalist systems are harsh and unequal. For those unable to compete we have social safety nets.For everyone else capitalist systems provide everything one could need or desire.

MY wife escaped from the Soviet Union in 1988. Believe me when I say you would rather be poor in a free country than rich in a socialist one. The continued socialization of the U.S. economy is really the only thing we have to fear.

McKibbinUSA said...

Hi Don, I copied your comments into my notes -- interesting views -- thanks...

Scott Grannis said...

Don: there's a lot of wisdom in your remark. The only plan we need is for the government to stop planning how the economy is going to work.

John said...

Does the author of this blog think that wealth and income inequality could ever become a problem? Is there a GINI index that is too high? If so, what would that be?

Do you see any connection between the growth of a class of super-rich with tons of cash to play with and the growth of crazy financial schemes we've seen in the last decade?

On another note, this constant trashing of government as the enemy of business and wealth is just plain silly. There's no currency without some kind of government. The economic growth we've seen over the past thirty years due to growth in financial services, insurance, and real estate (FIRE) has come with all of those sectors being highly regulated.

Where is the libertarian paradise? What country gets it right, in your view? Somalia?

Don Halldin said...

Not having a centrally planned economy is not the same as not having a Government.
Under a decentralized or free economy governments roll is to do the things government should do and only government is capable of doing. Such as defense of the boarders and safety of the people, defending the soundness and value of the coin or the realm, Create and maintain a social safety net for those through no fault of their own need such assistance, sound and thoughtful regulation of indispensable industries such as banking, defense contracting, and energy,public education. And not much else.
It must be obvious to anyone that the version of an overreaching government that the U.S. has had the past 10 years is an abject failure at all of these and everything else it has attempted.
I think it is time we recognized these shortcomings and try a different path.


DarkMath said...

To Scott Grannis,

"But inflation concerns will be relegated to second place for at least awhile, while markets breath a sigh of relief."

Are these the same markets that piled into Financial stocks in 2006, and before that Internet stocks in 1999. If so that sigh of relief is rather the sound of the oncoming steam engine.

I guess I shouldn't be surprise that your "economist" moniker has prevented you from reaching the following conclusion: there is enough money already in circulation offshore to stoke inflation. What happens domestically is superfluous at this point. Our fate lies in the kindness of strangers. If they begin to vote with their feet the resulting dollar devaluation will drive inflation through the roof. Add to that a Mad Man inside the Fed who has to print money to fill the gap and we have the brewings of hyper-inflation. The jack up in commodities this past month was only the opening salvo of what will be a brutal dollar collapse in the next 5 years. Of course your myopic view of our economy stops where the ocean meets the shore. You make no mention of our precarious position internationally. You've deluded yourself into thinking the recent ramp in GDP was some how unrelated to the 2 Trillion in monetary tiddliwinks. You've got your face firmly stuck in front of a tree. Thanks for the update on the pine bark, it really helps. Thanks to naive "economists" like yourself Joe Six Pack has no f'ing idea what is about to happen to him.

Mr. Kowalski said...

Question for all: Does the House Subcommittee overseeing The Fed have the right to stop the printing presses ? I've read that the Repubs plan on installing none other than Ron Paul as head of this subcommittee, and he will without a doubt attempt to stop the printing..

Buddy R Pacifico said...

Dark Math, your negative comments towards Mr. Grannis are completely unwarranted. Did you not read this post from 9:00am?

Ralf Graute said...

Dear Mr. Grannis,

I know it is a stupid question, but could you please tell me how to calculate the 6-month annualized growth rate for M2? I try to learn from you, but sometimes I get stuck.

Thank you for your help and have a good week.

Kind regards


Charles said...

Left to its own devices the economy will gradually recover from any shock and continue to grow. The current investment environment is very, very negative. But there haven't been and do not seem to be any surprises in the works. Thus, we should expect the economy to creep forward, adding new private sector jobs at a slow pace. There will be no deflation, there will be no double dip but there will not be any reduction in unemployment either. There may be an acceleration of inflation if the fed buys enough bonds or if the fed fails to raise the fed funds rate soon enough. Otherwise, we may see a gradual easing of inflation to the 0-1% level where it belongs.

M2 is created by a mixture of policy actions and private sector activity. Velocity is an unstable ratio of two weakly related numbers. Apparently, M2 grew faster in 3Q than nominal GDP. M2 is growing faster in 4Q than in 3Q. It is very hard to say what that means.

I believe there was a time when "velocity" was sufficiently stable or predictable that M2 could be targeted as a useful policy variable. Those days are long gone. The explosive growth and innovation of the financial sector over the last 30 years has privatized the creation of money to the point where the fed has little control over "money" and the monetary aggregates are little more than curiosities.

Scott Grannis said...

Ralf: to calculate the 6-mo. annualized growth rate, divide the current value by the value six months prior, square the result, then subtract 1.
Ex: (8773.3/8468.4)^2-1=7.3%

Scott Grannis said...

Mr. K: I don't think the House subcommittee can dictate or overrule Fed policies, but undoubtedly they could apply considerable pressure to the Fed if they chose to do so. One thing Congress could do to improve the workings of the Fed would be to change the Fed's mandate. Instead of a dual mandate (low inflation and full employment) it would be better to have a single mandate: low and stable inflation. There is a rule of thumb that applies here: if you have only one tool at your disposal (e.g., the Fed funds rate) you can only hope to hit one target (e.g., inflation).

John said...

I believe, based on recent history, it's naive to think the Republicans will curtail spending. We'll be watching. I assume Jerry Lewis, a Californian, has some good sunglasses and sunblock. As probable Chair of Appropriations, he may soon become like a "bug under a microscope."

marmico said...

Don, the day you figure out the difference between government purchases (consumption and investment) and expenditures (consumption, investment, transfers and interest on the debt) will be a day of infamy. Demography, bending the health care cost curve and the risk-free return on capital are the primary determinants of transfers.

Both political parties are different cheeks of the same butt. Take the latest working paper from Cogan/Taylor. They aren't worried about the multiplier of the ARRA stimpack, they are worried about the multiplicand. Taylor blogs here.

With that said, federal government purchases as a percentage of GDP have varied little in the last two generations (purchases primarily builds or declines in the defence bucket). The same cannot be said of expenditures.

The fact that Grannis is an outlier when it comes to real GDP growth should be disconcerting to you. Attack all you want. With your narrow lense, you seem to be a few panels shy of a full complement of neuron synapses. As the first poster notes, how trite (without an r*2).