Preface: This is my first article so please bear with me.

I
also want to establish that I am not an authority in anyway
regarding this subject. My goal here is to learn. Therefore, I
offer/ask to receive any critical conversation (open source- if
you will) that helps us all gain more information regarding
the intricacies of our financial system.
The Velocity of Money:
Many times when someone posts an article on LinkedIn
regarding the Federal Reserve's potential to increase interest
rates, a LinkedIn member comments regarding the Velocity
of Money (VoM) and how it relates to a potential interest rate
change. While I have a decent understanding of VoM, I
thought it would beneficial to spend more time researching
what is held to be one of the more important economic
statistics.
What is VoM and why does it matter?:
Directly from the St. Louis Fed:
The velocity of money can be calculated as the ratio of nominal gross
domestic product (GDP) to the money supply (V=PQ/M), which can be
used to gauge the economys strength or peoples willingness to spend
money. When there are more transactions being made throughout the
economy, velocity increases, and the economy is likely to expand. The
opposite is also true: Money velocity decreases when fewer
transactions are being made; therefore the economy is likely to shrink

As implied by the definition, the higher the VoM the stronger

the economy. The current VoM is ~4.39, which is the lowest

recorded annual data point, thus a sad statement on state of

our economy. See following graph.

Digging a little deeper, I found that the primary factors that

affect the VoM are a function of the demand for money by
individuals. We can breakdown the demand for money into
the transaction demand for money and the portfolio
demand for money.
"The transaction demand for money is the demand for money to
be used as a medium of exchange, or as a means of payment"

From what I read, it is this transaction demand for money

that is currently being debated in the blogs. Since higher
transactions result in a stronger economy (increased VoM),
everyone is concerned about the current historical low rate
of roughly four (4). This means that every dollar in
circulation transacts four (4) times which is far from the
average of the series @ fourteen (14) transactions.

The portfolio demand for money results from people's desire to

invest money, to serve as a store of value"

Delving further into the portfolio demand for money

concept, my research indicates that the portfolio demand
for money is a function of the lost opportunity cost of not
being invested in the markets. The reasoning focuses on
return and risk of a portfolio. For example, if one is only
earning 1% in a savings account then he/she may keep
monies in a non- interest bearing checking account (due to
better liquidity) as the lost opportunity cost is low.
Alternatively, if the lost opportunity cost is high, then the
demand for money will be low since folks will want to be
invested.
Connecting the dots, it becomes obvious that if monies are
being invested then transactions should be lower as
monies are off the table finding a home invested in the
markets.
Math and the Equation:
At the St. Louis Fed, you will find a simple form of the VoM
equation:
Gross Domestic Product/St. Louis Adjusted Monetary Base
(GDP/M)
Everyone should know that the monetary base has grown
significantly due to the Feds QE programs. As the Fed
increases the monetary base (M) exponentially then by
function (ratio) the VoM is going to decrease. Hence, it can
be said, Velocity is useless without a stable monetary
supply. h/t EV.
The other side of the Formula:
In considering the math, it is important to understand the
GDP side of this equation. The GDP calculation has a
number of variables; however, I am going to simplify my

analysis to say that it is the result of the consumers ability

to make purchases for good and services hence
transactions. The financial health of the consumer is a
determinant of his/her purchasing power so it follows that
it should translate into more or less transactions VoM. It
appears to me the consumer is tapped out due to the
lack of wage growth. See the following graph:

I am not going to venture into the employment statistics

or the increased costs of health and housing. Let us just
agree that the consumer has less to spend beyond the
necessities of life. As a result, GDP estimates continue to
stagnate and in some studies show signs of decline.
Predictive or Tail Risk:

When I started this research, I wanted to determine the

effects of any increase in interest rates on the VoM. In
addition, as I mentioned earlier, a number of LinkedIn
commenters have suggested that VoM would increase
should rates increase. While intriguing, I find that VoM is
not going to increase in any meaningful way should the
Fed implement the suggested 25 basis points hike.
I support this position by indicating that the increase
being so heavily discussed is only an increase in the
Interest of Excess Reserves (IOER) of 25 basis points and
that there is a long translation to the average consumer
of this increase. Moreover, if the increase were
significantly larger, the consumer would migrate to more
of an investment profile and not necessarily spend.
Again, this results in a reduction of transactions.
In terms of predictability, one would have to look at the
historical increase in the monetary base and possibly
question the validity of the VoM. If the Fed continues its
easing programs exponentially faster than the consumer
can transact, then the VoM does become less important
in terms of an economic indicator.
Finally, while the VoM is not a stock or portfolio, I did
have to ask if such a low VoM ratio represents the
dreaded tail risk that investment professionals try to
hedge against. I did a quick standard deviation () of the
data points (86) supplied by the St. Louis Fed resulting in
a of 4.94. Statistically then, with a of roughly five (5),
the current VoM ratio is approaching three standard
deviations from the mean of fourteen (14). Interestingly,
the VoM ratio fell ten (10) handles from 2008 to 2014.
We all know why!
Summary:
I propose that any conversation about the Velocity of
Money increasing because of a Fed hike is rather off base.
Further, with the continuous central bank intervention in

monetary policy (QE), the less reliable the VoM has

become as a valid economic indicator. Therefore, it
appears the VoM is more tail risk than predictive.