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Velocity, Uncertainty & the Economy

October 29, 2012

Milton Friedman postulated that velocity was either stable or grew at a stable rate. However, a panic – like the US had in 2008/2009 – obviously can cause a decline. And it is also apparent that quantitative easing, which boosts excess reserves held at the Fed, can also lead to a decline in the amount of GDP supported by a certain amount of money.
-Brian Wesbury, chief economist, First Trust Advisors

Recently we lifted our recession odds to 25% from 10%. For some, this was worrisome. In recent weeks we’ve been asked, “If you guys get a little bearish on the economy, after being bullish for so long, shouldn’t I get really nervous?” Our answer to this question is “no.”

Our base case (75%) is the economy continues to grow. Not gangbuster growth; more plow horse data, such as the 2% real GDP growth for Q3 and what we expect to be a workmanlike 120,000 increase in payrolls for October.

We were focused on the potential for a drop in velocity – the turnover rate of the money supply. To put this in plain English, the M1 money supply (cash and checking accounts) stands at $2.4 trillion; M2 (M1 plus savings deposits, short-term time deposits, and retail money market funds), is $10.1 trillion. And, in the past year, total spending in the economy (nominal GDP) has been $15.5 trillion.

Velocity measures how often each dollar is spent. Dividing GDP by M1 shows that every dollar of M1 is spent 6.6 times while every dollar of M2 is spent 1.5 times. Both are down significantly in recent years (and even in recent quarters), partly because of quantitative easing which has artificially boosted M1 and M2 without any kick to GDP growth.

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