Velocity of money drives core inflation?

Tom Traill - 22 August 2019

Monetarism’s glory days are long gone, but in some quarters there is a nostalgic presumption that money supply data is still a useful leading indicator of inflation. This is emphatically not the case, so much so, that over the past 20 years, money velocity has established its own credentials in this role. Using US data as an illustration, a simple model predicts that core inflation will head higher over the coming months.

Monetarism is an empirical proposition based on a behavioral interpretation of the Fisher equation (identity) MV=PT, where M is the quantity of money, V the velocity of the money stock, P the price level  and T the volume of transactions (or the level of real GDP). While all four ingredients are time-varying, the monetarist premise is that the trend rate of real GDP growth exhibits little variation and that the velocity of money (V) is also relatively stable (in the absence of institutional change).  Hence, the dominant source of variation on the left hand-side of the equation is M and on the right-hand side of the equation is P. Cast in first difference terms, the active transmission is from money stock growth to inflation.

For thirty years – from the 1960s to the late-1980s – the velocity of the US M2 money stock was broadly constant, satisfying the monetarist assumption. There followed a rise in velocity which peaked in 1997, and a steady decline over the past two decades (figure 1).  While financial de-regulation played a part in the destabilization of velocity in the 1980s and 1990s, the slope of the government yield curve has been the most powerful determinant. The steeper the curve, the greater the opportunity cost to holding low-yielding bank deposits and the faster the circulation of the money stock.

Since the mid-1990s, it is the velocity of money, not the quantity of money, that provides a leading indication of the trend in core inflation, as shown in figure 2. With uncanny precision, the twelve-month change in M2 velocity has provided valuable information about future inflation with a lead of approximately 15 months.

Readers of our Global Inflation Heatmaps will already be aware of the current strength of US core inflation, standing at 2.2 per cent per annum in July, up from 2.0 per cent in May and having remained above 2 per cent since March 2018. This is despite the prevailing atmosphere of deflationary concern, and likely to be buoyed further by potential short-term interest rate cuts, or at the least unlikely to be impeded by rate rises. Efforts to preserve an upward-sloping yield curve – between 2 and 10 years – will tend to preserve the inflationary bias. Bond investors may be tempted to take their 2019 profits and run.

Figure 1: 

Data source: St Louis Federal Reserve

Figure 2: 

Data source: St Louis Federal Reserve

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