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Upon Further Review 4Q 2022: Money Supply & The Velocity of Money

01/11/23

INTRODUCTION
As we look back on 2022, we remain in awe of how trying of a year it was for financial markets. To be sure, interest rate increases by the Federal Open Market Committee (FOMC) to combat inflation – the most aggressive rate hiking cycle on record – were a critical driver of asset repricing throughout the year. As we look forward into 2023, we wonder if this tightening cycle can be effective in curbing inflation without triggering an economic recession. In this installment of Upon Further Review, we explore a less frequently discussed driver of inflation by exploring two topics: Money Supply and the Velocity of Money.

MONEY SUPPLY (Monetary Base, M1 & M2)
Money supply is a relatively straightforward concept, yet its importance cannot be understated. The domestic money supply is classified by three different buckets, and tiered by liquidity from money that is most circulated, to money that is held in savings and therefore not spent very frequently. We will begin with reviewing the first category: M0 (commonly known as the monetary base), which is the most liquid and consists of all currency in circulation and held in bank vaults. Next is M1 that includes everything in M0, as well as checking account balances held at banks (in other words, the money we use for our daily spending). Lastly, M2 money supply includes everything in M0 and M1, plus savings deposits and money market accounts.1 It is the M2 money supply that serves as a key leading indicator of future inflation movements, and therefore the most important one for us to understand. Simply put, the more money there is in circulation, the lesser the value of each unit of currency, thereby requiring more units of currency to purchase the same basket of goods.
 
Now that we understand how the Federal Reserve classifies the money supply, let us revisit the uncertain days immediately preceding the onset of the Covid-19 crisis. As the virus began to spread and the “Great Shutdown” commenced in the United States and beyond, financial markets were roiled to an unprecedented scale: March 2020 was the most volatile month in equity markets on record. In response, government leaders sprang into action by providing substantial aid in the form of both monetary and fiscal policy. Monetary policy enacted by the Fed cut interest rates to near zero and included unprecedented quantitative easing via asset purchases. Meanwhile, Fiscal policy measures led by the Treasury Department authorized the issuance of multiple rounds of stimulus checks, hoping to prop up consumer spending. The result was a proverbial tidal wave of fresh currency, as money was printed to offset the economic fallout from the novel coronavirus.


Source: Federal Reserve Bank of St. Louis

The effect on money supply – expressed here in the context of United States M2 money supply – was swift and unrivaled in scope. Indeed, M2 money supply increased 24.2% from March 2020 to March 2021.

MONEY VELOCITY (MV = PQ)
The rapid increase in money supply does not tell the full story, however, as there is another side of the coin (we are discussing currency, after all): Money velocity. Money velocity represents the number of times a unit of currency is used to purchase goods or services.  Money velocity drives inflation because the more times currency changes hands, the more robust the economic activity, thereby increasing competition for goods and services and driving prices higher. M1 money understandably has a higher velocity ratio than “stickier” M2 money: a one-dollar bill in your pocket, for example, is much more likely to be “turned over” in a transaction compared a single dollar held in your savings account.
 
A particularly important distinction is that money velocity is not constant, as it is made of up of multiple parts. In fact, the most recent velocity of M2 money supply registered 1.191…well below its 50-year average of 1.7811 and its 10-year average of 1.4060.2
 
The impact of the velocity of money is expressed mathematically in the following relationship:

MV = PQ
or
Money Supply x Money Velocity = Price Levels x Economic Output 

This equation represents a view of inflation in its most basic form: M (money supply) x V (money velocity) = P (price levels) x Q (economic output or gross domestic product).
 
What can we learn from this formula? We know that the current rate of “V” (M2 money velocity) is 15% less than its historical 10-year average, and 33% less than its historical 50-year average, and that “Q” (economic output through the first three quarters of 2022) was not very robust. If we cancel out these two variables (money velocity and economic output), we are left with the significant increase in money supply as the primary driver of higher price levels (inflation).
 
APPLICATIONS TO 2023 ECONOMIC OUTLOOK
How can a seemingly obscure mathematical equation be put to practical use as we move into 2023? We believe the answer lies in the relationship between two key data points: 1) the rate of growth in money supply and 2) the annual change in consumer prices. Recall that we mentioned earlier that M2 money supply is considered a leading indicator of future inflation paths. Specifically, the growth in M2 money supply is highly correlated with the consumer price index (CPI).


Source: FEG Investment Advisors

On the chart above, M2 YoY has been shifted forward 15 months on the timeline, so that its peak of 26.9% in February 2021 aligns with what appears to be the peak of the CPI at 9.1% in June 2022. Should this analog hold, it would suggest inflation is set to fall to more normalized levels over the intermediate term, thereby setting the potential stage for the FOMC to eventually shift to a more accommodative monetary policy.
 
Make no mistake: caveats abound. This analog could diverge and prove a false flag. Sustained strength in the labor market may pressure the CPI for services, geopolitical risks remain elevated, and black swan events will forever be a concern. With that being said, the above graphic supports our consensus that inflation has peaked, and – consistent with our prior commentary – what matters most in influencing FOMC policy as we enter 2023 will be the speed at which inflation declines.

To discuss more with an expert or put your financial plans into perspective, contact a member of our wealth management team.

References:
1Federal Reserve Bank of Richmond:  https://www.richmondfed.org/publications/research/econ_focus/2019/q1/jargon_alert(Opens in a new window)
 
2Bloomberg Data: VELOM2 Index:
Data as of 9.30.22, 10-Year Average: 9.30.2012-9.30.22; 50-Year Average: 9.30.72-9.30.22
 
3Federal Reserve Bank of St. Louis:
Wen, A., Arias, M., 2014; What Does Money Velocity Tell Us about Low Inflation in the U.S?  Federal Reserve Bank of St. Louis On The Economy Blog
https://www.stlouisfed.org/on-the-economy/2014/september/what-does-money-velocity-tell-us-about-low-inflation-in-the-us(Opens in a new window)
 
 
For more information about our Wealth Management services, speak to your relationship manager, or visit the Wealth Management page of SunflowerBank.com.
 
 
Investment and insurance products are not FDIC-insured, are not a deposit or other obligation of, or guaranteed by the bank or an affiliate of the bank, are not insured by any federal government agency and are subject to investment risks, including possible loss of the principal amount invested.​
 
 
General disclosure: This material is intended for information purposes only, and does not constitute investment advice, a recommendation or an offer or solicitation to purchase or sell any securities to any person in any jurisdiction in which an offer, solicitation, purchase or sale would be unlawful under the securities laws of such jurisdiction. This material may contain estimates and forward-looking statements, which may include forecasts and do not represent a guarantee of future performance. This information is not intended to be complete or exhaustive and no representations or warranties, either express or implied, are made regarding the accuracy or completeness of the information contained herein. The opinions expressed are as of December 30, 2022, and are subject to change without notice. Reliance upon information in this material is at the sole discretion of the reader. Investing involves risks.

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This article contains general information only. Sunflower Bank, N.A. is not, by means of this article, rendering accounting, financial, investment, legal, tax, or other professional advice or services. This article is not a substitute for such professional advice or services, before making any decisions related to these matters, you should consult a qualified professional advisor.