One of the more obscure indicators economists use to gauge the strength of the economy is money velocity. In essence, this is the speed at which a dollar moves from one transaction to another. The more times a dollar is used to buy something, the greater its velocity, and the quicker the economy grows.
More than four years after the recession ended, you’d think money would be cycling through the economy at a faster rate than a few years ago. But you’d be wrong. Dating to 1959, money has never moved through the U.S. economy at a more glacial pace than it has over the past year. As of the third quarter of 2013, the velocity of the M2 money supply—cash and checking deposits, plus “near money,” which includes savings accounts, retail money market mutual funds, and CDs—was 1.5, according to data tracked by the Federal Reserve. This means that of the $11 trillion in bank accounts (not to mention all the cash stuffed under mattresses), each dollar was spent just 1.5 times over the past year. That’s down from 2 times in 2006 and a high of 2.2 times in 1997.
Because money velocity is roughly the ratio of the size of the economy (gross domestic product) to the size of the money supply, it’s no wonder money is moving so slowly. In 2008 the Fed began its aggressive quantitative-easing program of monetary stimulus that included buying bonds and flooding banks with capital in hopes of spurring lending and investment. Since then, the money supply has grown about 46 percent. GDP has averaged only 2.3 percent annual growth since the recession ended in June 2009.
With all the money the Fed has pumped into the economy, GDP would have to grow almost 10 percent annually for money velocity to keep pace with the money supply. And since this isn’t China, that type of growth isn’t remotely plausible. This also explains why all that new money hasn’t triggered inflation: If it’s not getting spent, it’s not raising prices. “We’re simply not going to get inflation until velocity gets back to something normal,” says Austan Goolsbee, a former chairman of President Obama’s White House Council of Economic Advisers.
Money tends to slow down in the early stages of an economic recovery as people reduce spending, pay down debt, and increase their savings rate, and it doesn’t pick up speed until about four years into a turnaround. During the economic boom of the 1960s, annual GDP growth averaged more than 5 percent from 1961 to 1965, but money velocity fell during much of the first half of the decade and didn’t bottom until the end of 1964, at about 1.6 percent—not far from where we are today. Afterward, the economy ticked off another five years of solid growth, as the money speed indicator started rising. Twenty years later, something similar happened. After a deep recession in the early 1980s, the economy went through almost a decade of growth. And yet money velocity fell during much of that recovery, bottoming in 1987 and then racing up through the late ’90s. “To me, this is totally normal,” says James Paulsen, chief investment strategist at Wells Capital Management, who has studied the variations in money velocity through the years.
Based on these historical examples and improving economic data, we may be on the verge of money finally speeding up again, especially as the Fed tapers its bond purchases and mops up excess liquidity, slowing the expansion of the money supply. This would in theory lead to stronger growth, but it could also unleash some moderate inflation. That’s not entirely a bad thing if rising prices boost spending. Some economists think the Fed wouldn’t mind a small inflation jolt. “This is not your father’s Fed,” says David Rosenberg, chief economist at Canadian investment firm Gluskin Sheff + Associates (GS:CN). “When it comes to inflation, this is a Fed that will say, ‘Bring it on.’ ”