Money matters enormously to the future of spending and investing in the economy. If the Federal Reserve pumps a large amount of cash into the economy, or removes a large amount, you’re going to see similar swings in prices that will of course influence consumer and investor behavior. The thing is, it doesn’t happen right away. A Fed action today won’t matter much until next year. And that’s where speed comes in. If we want to know how the economy is behaving right now, we should be watching how fast the money is changing hands.
Here’s some background. When the Fed, worrying unnecessarily about an overheating economy, deflated the monetary base in 2000, it set up a contraction. Hence, we saw significant price declines in 2001. When the Fed engineered a recovery of liquidity in 2001, especially after the September 11 terrorist bombings, it set the stage for the economic expansion and domestic price stability we’re enjoying this year.
That said, there’s a strong case to be made that the velocity, or turnover of money, is even more important than the money itself. In other words, the Fed can inject plenty of new money into the economy, but if that liquidity circulates from hand-to-hand at a very slow rate, or even at a declining pace, then the economic power of money is completely neutralized.
On the other hand, even if the Fed is slow about adding money, rapid turnover and hand-to-hand circulation of money can become a very powerful economic influence. Historically, this velocity quotient of money is nowhere near as stable as some monetarists contend. So capturing the swings of money turnover is therefore a really important forecasting tool, and one that investors should use more often.
Thing is, unless you’re looking in the right places, velocity might be hard to see. But research has shown that changes in money velocity are closely linked to shifts in the commodity futures indexes. In 1999, a strong economic growth year, the CRB futures index moved significantly higher, as did the velocity turnover rate of M2 (a conventional measure of money and credit). They both plunged in 2000 and most of 2001. The CRB told the story — and ahead of time.
Monthly and quarterly M2 figures are released by the Fed with a lag. But the CRB futures index is traded daily. Hence it provides a day-to-day forecasting tool. And what’s it telling us now? In recent months the data suggest a rebound in commodities and the rate of circulation of money. That’s a good sign for the economy. Any upward shift in velocity will result in a much bigger rise in nominal GDP than occurred last year. With prices generally stable — excluding the temporary oil shock — nearly all the increase in money GDP will translate to faster expansion of real GDP.
One thing’s for sure. All the gloom and doom currently surrounding stock prices is unwarranted from a macro-economic standpoint. Not only is last year’s monetary stimulus now working its way through the system, but lower tax rates on individuals and small businesses, along with reduced tax burdens on the cost of building and buying new business equipment, will also add to economic growth.
Hopefully investors will keep their eye on the larger forest, rather than the individual trees. Instead of yelling timber because a certain stock is falling, they should stand back and view an economy that’s standing tall.