The ERP posts the last couple of days are useful for highlighting a bigger issue – the impairment of the monetary transmission mechanism. This topic is particularly important because, by definition, that is how central bank policy impacts economic activity. Given how discussion of central bank policies is ubiquitous these days, it is somewhat surprising that the discussion of the transmission mechanism has been minimal. It appears that most participants are just assuming that the mechanism will continue to work as it has in the past. I will attempt to analyze this issue a bit more and conclude with some extrapolations.
Monetary transmission is, by definition, how an additional unit of money gets converted to economic activity. ‘Money’ and ‘Economic Activity’ mean different things to different people, so for simplicity, I will define Money as M2, and Economic Activity as Nominal GDP. M2 includes currency in circulation and deposits – in effect money that is readily available for consumption. (It does not include excess reserves to avoid double counting, since customer deposits at JPM can be in turn deposited by JPM at the Fed. It is important to note, however, that even though excess reserves are not included, the QE created money is included) Mathematically, then, we can use the ratio of Nominal GDP to Money as an indicator of monetary transmission. That ratio, of course, is also called the velocity of money.
There are lots of ways to think about money velocity, but the view I want to explore here is the willingness of the private sector to increase consumption per unit of liquidity. In other words, it is the amount citizens and corporations will spend of every additional dollar they accumulate in their bank account. By looking at it this way, it is easy to see how this metric is an indirect measure of how effective QE is at stimulating economic growth. The higher the velocity, the more effective money creation is, and vice versa.
Using those definitions, it should not be surprising to see how a higher velocity could lead to faster growth, as well as higher financial leverage. Conversely, falling velocity could lead to decreasing growth and leverage. The chart below illustrates this relationship, with the S&P 500 PE ratio in blue, and money velocity in red. The coincidence of these two factors over longer periods of time appears evident:
As we know, both money velocity as well as the PE ratio is at relatively low levels. The hypothesis here, then, is that the current low level of velocity reflects a weak money transmission channel, which is part of the reason why equity valuations have remained very cheap even as monetary expansion is being used to richen treasury bonds.
With consensus expectations for strong recoveries in European and Japanese equities next year because of more monetary expansion, I think the above point is especially pertinent. The low level of money velocity across the developed world suggests that the impact of this money expansion on economic activity as well as equity valuation next year will be quite small. The chart below shows money velocity across countries, with the US in orange, Japan in yellow, and Europe in white. (An average of French and Italian velocity is used as a proxy pre-1995 in purple)
What does this mean longer term? To answer that, it probably makes sense to think through the drivers of velocity, which remain not well understood. A list, however, would probably include:
- Demographics – because people nearing retirement are less likely to spend and more likely to save, more elderly means decreasing velocity
- System Leverage – because deleveraging = saving, which by definition means less money for consumption, deleveraging decreases velocity
- Wealth Distribution – because the wealthy save a lot more than the non-wealthy, greater wealth inequality increases saving and decreases velocity
Unfortunately, all of those factors suggest stable to lower velocity in the years ahead. However, it is worth noting that the government has the power to change this. A central government that runs persistent and growing budget deficits, in excess of nominal GDP growth and financed by central bank printing, essentially forces the printed money to circulate. This will increase money velocity, but takes the country down the path of the Weimar Republic.
On the positive side, however, since QE didn’t do that much for equity valuations, a withdrawal will probably not hurt much. Note that this refers to a decrease in money, and not to an increase in interest rates.
- US Retail Sales Control rose 0.5% in Nov vs 0.3% exp and -0.1% prev.
- US Jobless Claims decreased to 343k last week vs 369k exp and 370k prev
- Fri: EU PMI, EU CPI, USCPI, US Markit Preliminary PMI
- Mon: RBA Minutes,
- Tue: US NAHB Index, Japan Trade Balance
- Wed: German IFO, BoE Minutes, US Housing Starts,
- Thu: US Jobless Claims, Philly Fed, Existing Home Sales
- Fri: Quadruple Witching, Canada CPI, US Durable Goods Orders,