James W. Paulsen, Ph.D.

Economic and Market

February 27, 2014

Perspective
Bringing you national and global economic trends for more than 30 years

Is Monetary Velocity Finally Rising???

Although money supply velocity (i.e., the turn of the money supply or how much nominal GDP is produced by each dollar of the money supply) declined again in the fourth quarter, there are growing indications it may finally be starting to rise. As we have discussed elsewhere (see Economic and Market Perspective from November 11, 2013), the direction velocity takes this year may prove critically important both for the economy and for the financial markets. Chart 1 shows money supply velocity since 1960 during both expansions and contractions. Velocity typically declines during the early years of economic recoveries as it has again in the contemporary recovery. Many believe the traditional monetary mechanisms have been broken in this recovery. Fallout from the Great 2008 recession is expected to keep velocity muted for some time. However, velocity has eventually turned higher in every post-war economic recovery and usually rises thereafter until the next recession. Indeed, there is nothing irregular about the chronic decline in velocity so far in this recovery. For example, it fell nearly as long during the beginning of the 1960s, late-1970s, and 1980s recoveries before finally turning higher.
Chart 1: Velocity of M2 Money Stock (M2V) Source: Federal Reserve Bank of St. Louis

Currently, many are focused on the Federal Reserve as they begin tapering their quantitative easing program and are trying to gauge how long before the Fed begins raising short-term interest rates. However, the most important monetary event during the rest of this recovery may not even involve the Fed. In our view, monetary policy will be primarily defined from here by if, when, and how fast money supply velocity rises? Should velocity uncharacteristically continue to weaken, concerns about disappointing economic growth are likely to return, anxieties about deflation will intensify and questions surrounding whether the Fed is out of bullets will escalate. Conversely, if velocity follows its historical pattern and does soon begin rising, attitudes and concerns will be quite different. Suddenly, both real and nominal economic activity would improve (as spending propensities are boosted by a faster turn in the money supply), most inflation measures would rise, the Fed would be forced to accelerate its tapering program and initiate rate hikes, the bond market would likely get spooked and reprice long-term yields higher and finally good news for the economy may become bad news (because of overheated fears) for stocks.

Indications of rising velocity

In the last couple quarters, a few indicators now suggest velocity may be turning up. First, borrowing and lending propensities have improved. Second, commodity prices have recently risen and core producer price inflation has accelerated. Third, the pace of private nominal economic activity has accelerated sharply in the last six months. Fourth, private sector money velocity has risen in each of the last two quarters. Finally, the performance of the stock market in the last year is consistent with past recoveries during periods preceding when velocity first turned higher. 1. Lending and borrowing propensities improve A significant sign of improved spending propensities often associated with rising velocity is better loan growth. In recent months, both consumer and business lending has accelerated. Total U.S. consumer debt (Chart 2) rose by the most in more than six years during the fourth quarter of last year. In addition, as shown in Chart 3, after being lethargic during much of 2013, total U.S. bank loans since late last year have risen at one of their strongest paces of the recovery.

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Chart 2: Household debt rises Source: Bloomberg

November and is currently at its highest level in more than a year. Although bad weather across the country may be temporarily elevating some agricultural prices, the recent rise in commodity prices seems broadly based. Chart 5 shows industrial commodity prices, those most sensitive to economic activity, have risen by almost 7% from their November low.

Chart 4: ThomsonReuters/Jefferies CRB Commodity Price Index

Chart 3: Total U.S. bank loans

Chart 5: Journal of Commerce Industrial Commodity Price Index

Renewed evidence of credit creation follows a massive reconstruction of the financial industry. In recent years, banks have been recapitalized, bad debts have been purged, foreclosures have declined to their lowest level since 2005, and lender surveys now show renewed willingness to make loans. While overall credit creation remains subdued relative to historic norms, it is finally rising again implying money velocity is likely to soon improve. 2. A couple price pressures Often a quicker turn in the money supply is associated with heightened inflationary pressures. Today, while there is very little evidence of an imminent inflation threat, there are a couple indications this may be starting to change. First, as shown in Chart 4, the CRB Commodity Price Index has soared by more than 10% from its recent low in

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Moreover, as shown in Chart 6, the annual rate of core producer price inflation bottomed in August at 1.2% and has since accelerated for the first time in almost two years to 1.7%. As illustrated in the chart, producer price trends typically lead consumer inflation. Will the core consumer inflation rate also soon accelerate? While none of these signs suggest a serious inflation problem lies just ahead, they do portray a different tone which may be caused by an upward turn in monetary velocity.
Chart 6: Annual Core Consumer (solid) and Core Producer (dotted) Price Inflation

Chart 7: Annual growth in Nominal Private Sector GDP Total nominal GDP less total government purchases and investments

4. Private sector money velocity is already rising Private sector monetary velocity (i.e., private sector nominal GDP divided by the M2 money supply) has increased in each of the last two quarters and is up year over year for the first time since the very beginning of the recovery (Chart 8). This rise in private sector velocity is due to a combination of improved economic activity and slower money supply growth. Indeed, private GDP growth has accelerated close to 7% while the annual growth rate of the M2 money supply has slowed to a three-year low near 5.5%. Overall, money velocity is likely to soon increase since nominal GDP now only needs to rise by 5.5% to be growing faster than the money supply. 3. Private sector GDP has accelerated Perhaps the best signal suggesting improved money velocity is accelerating economic activity. When velocity rises, the money supply is turned over at a faster pace boosting economic transactions. Chart 7 shows the annual growth of nominal private GDP has increased from about 4% a year ago to about 7%. In the last two quarters, nominal private sector GDP has risen at an annualized pace of 6.7% compared to an annual average growth rate of only 4.7% during the first four years of this recovery. Nominal public sector growth contracted last year, but it is not the public sector of the economy which responds to monetary velocity. Rather, public sector growth is driven by past or present legislative actions and is often contrary to private sector activity (e.g., unemployment insurance outlays slow as private sector growth accelerates). Consequently, the fact private economic activity has risen close to its fastest pace of the recovery is indeed strong evidence that money supply velocity has increased. Most importantly, however, the fact in recent quarters a slower growing money supply is producing accelerating private economic growth is a powerful indication money velocity may have finally turned higher.
Chart 8: Annual growth in M2 Money Supply Velocity Private Sector Velocity (solid) vs. total velocity (dotted)

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M2 money supply velocity (solid)

In a similar fashion, is the contemporary stock market rally during the last year signaling that 2014 is a velocity turn up year? Does the persistent upward run in stock prices of recent months (even in the face of weather impacted disappointing economic reports) reflect a stock market sensing economic improvement because money velocity is bottoming?

Chart 11: U.S. stock market vs. money supply velocity 2003 to 2005

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M2 money supply velocity (solid)

S&P 500 Stock Price Index (dotted) natural log scale

S&P 500 Stock Price Index (dotted) natural log scale

Eventually, however, rising velocity has usually led to intensifying overheated/inflation fears, rising bond yields, and a reversal in the Feds accommodative policies frequently causing the stock market to struggle. Charts 9, 10, and 11 illustrate three such velocity turn up years in the post-war era. In each case, the solid line is money velocity and the dotted line is the stock market. In all three recoveries, as velocity neared it cycle low, the stock market roared higher (e.g., in 1965, 1987, and 2003). Eventually, though, once it becomes clear velocity has turned higher, good news on the economy often becomes bad news for the stock market and a correction results. The stock market suffered more than a 20% collapse in both 1966 and 1987 and almost a 10% correction in 2004.

Chart 10: U.S. stock market vs. money supply velocity 1986 to 1988

S&P 500 Stock Price Index (dotted) natural log scale

M2 money supply velocity (solid)

5. Is stock market reflecting improved money velocity? Traditionally, when money supply velocity first turns higher, the stock market has done well. Initially, as velocity bottoms, economic momentum improves boosting stock prices as investors correctly sense a forthcoming quickening in the pace of economic activity.

Chart 9: U.S. stock market vs. money supply velocity 1964 to 1967

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Will good news become bad news?

Since the end of 2012, the S&P 500 Index has risen by about 30%. Throughout this period, money velocity has continued to decline and it is widely expected to remain weak for the foreseeable future. However, global economic activity has been broadening and has synchronized in a manner which may suggest velocity has already begun to improve. In the U.S., adjusting for the temporary impact of an uncommonly bad winter, real GDP growth is probably in excess of 3%. Moreover, real private sector GDP growth has risen by a robust 5.1% annualized growth in each of the last two quarters. With sequester ending and the public sector contraction during 2013 fading, overall real GDP growth in the U.S. may average a stronger-than-expected 3.5% this year. Chart 12 compares the contemporary stock market run with money velocity. While overall money supply velocity is still declining (solid line), private sector velocity has been rising in the last couple quarters (long dotted line). Will overall velocity soon follow private sector velocity higher? Is 2014 a velocity turn up year? Will it rhyme a bit with 1966, 1987, and 2004? Currently, good news for the economy is good news for the stock market. Better-than-expected global economic momentum has been the primary catalyst driving stock markets higher. If velocity does begin to rise, however, similar to past velocity recovery cycles, will this positive force eventually turn negative for the financial markets? That is, will good news on the economy eventually become bad news for stocks?
Chart 12: U.S. stock market vs. money supply velocity 2013 to 2014?

If the solid line in Chart 12 does turn higher this year, how will investors react? Will investors and the Fed worry over potential inflationary fallout from rising velocity and $3.5 trillion in excess bank reserves? Will these fears intensify if commodity prices continue to rise, core consumer price inflation rises, or if wage inflation accelerates as the unemployment rate drops toward 6%? Will the 10-year bond yield spike higher again this year? Wont bond investors incorporate potentially stronger nominal economic activity if velocity rises? Finally, will the Fed be forced to normalize its policy more quickly than anticipated? We began 2014 with a modest stock market correction due to underheated fears as investors worried the economic recovery was slowing. Before the year is over, we would not be surprised if the stock market suffers another correction due to overheated fears produced from concerns about a rising velocity. Should an overheated correction eventually materialize this year, however, our guess is the stock market will likely rise further first (perhaps reaching a high near 2000 this year) before higher bond yields, elevated inflation concerns, and an abrupt change in Fed policy perhaps forces the stock market back close to where it started the year (1850ish). While the outlook for equities in the next several years remains optimistic and buy and hold investors will likely be rewarded handsomely, getting through a velocity turn up year here in 2014 may prove frustrating for stock investors.

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S&P 500 Stock Price Index (small dotted)

M2 money supply velocity Total velocity (solid) Prtivate sector velocity (large dotted)

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