Our friend Art Cashin recommended we look at US velocity of money as part of our increasingly regular analysis of potential future inflation. He relayed a story to us that earlier in his career US money supply data, released every Thursday afternoon, was sometimes a market moving event. Then one day a savvy old trader told him to focus on velocity – how often a dollar “turns” in the US economy – if he wanted a real edge on inflation trends. Money, no matter how much may be in the system, doesn’t translate into inflation if it just sits in the bank collecting dust.
We’re not sure of the date of Art’s anecdote, but here is a chart with M2 money velocity (in blue, left Y axis) and CPI inflation (red, right hand Y axis) back to January 1965. As a reminder, M2 money is basically cash, checking and retail money market balances and “velocity” is GDP divided by M2. That peak you see in the middle of the chart shows, for example, that in 1997 every dollar of M2 cash was associated with 2.2 dollars of GDP (i.e., it “turned” twice in that year).
We see 3 things going on here:
- The left part of the chart, from 1965 – 1981, clearly shows that rising inflation (red line) came with higher M2 velocity (blue line). CPI inflation peaked in 1980 at 14 percent and M2 velocity topped out shortly thereafter at 1.9x. As velocity dropped through the 1980s, so did inflation. So far, so good. A nice clean relationship.
- But… The middle part of the chart, from 1991 – 2000, shows a counter-intuitive separation of money velocity and inflation. The former goes to new highs of 2.2x, but the latter remains contained. Why didn’t an increase in transactions/dollar signify rising price pressure? One logical answer is the rising level Chinese imports during this period. These put persistent pressure on prices.
- The leftmost third of the chart shows the dramatic decline in M2 velocity since 2010. Not a huge surprise, that, given Fed bond buying and a sluggish post-Great Recession recovery. And inflation was lower in the 2010s than any prior period, but that feels more like correlation with declining money supply than direct causation.
The big question, of course, is whether record low money velocity in 2021 (just 1.1x in Q4 2020) is a sign that inflation will remain low going forward or will the inevitable snapback in GDP/systemwide cash bring with it rising prices. Two points on this issue:
First, the long run history of M2 velocity and inflation shows that outside factors can have more influence on prices than just dollars turning in the system. That is what happened in the 1990s. Back then, it was Chinese imports. Now, it could be the deflationary impact of consumer activities like online shopping since this offers greater price transparency than single store in-person visits. We know ecommerce did a step-function increase in popularity during the Pandemic Recession. We don’t yet know if or how that will alter inflation trends. Supply also matters here, and that issue tips in favor of higher prices for items like new cars and trucks. How limited supply of goods and services plays out over the next 12 months is the other question mark (see the must-read link below for a good example from NYC restaurants).
Second, rate of change matters a lot. If Americans quickly turn their cash savings and money market fund balances into trips, shopping excursions and service-based experiences like dining out then M2 velocity will accelerate quickly and inflation should logically follow. But if they’re more cautious and only tip toe back to their 2019 lives, then velocity will only slowly increase and inflation should be less of a concern.
Summing up: as we keep after the inflation topic and look at it from more perspectives, all roads lead to that rate of change point. Strange as it may sound, we think the market has settled on the idea that American consumers will only slowly return to old habits. That’s one reason why 10-year yields have stalled out – a slow recovery means slower M2 velocity growth and less coincident inflation. A slower recovery is also a more long-lived recovery, one that can spread into 2022 and even 2023. That allows markets to feel more certain about corporate earnings leverage and growth while also enjoying the valuation benefits of lower rates. All this certainly explains why the S&P keeps making new highs …