What is the Velocity of Money?
Clients have surprisingly asked us, “what is the velocity of money” and “how does it work in the real world”? We’ll keep this simple. Let's jump right in!
Velocity of Money: The rate at which people spend cash. If the velocity of money is going up, then more transactions are occurring between individuals in an economy. This means more money being spent with one another (peer-peer, peer-business), which can be an indication of potential price increases in the longer term. More money chasing the same goods.
On the other side of the coin (no pun intended), less money is being saved. As we will find out shortly, this is one of (many) indicators that professionals, and others take into account when analyzing trends, and the broader outlook. We can also flip this explanation on it's head if the opposite is occurring (which is what's happening now), if the speed of cash moving hands is at a virtual stand-still.
Why does it matter? If money is quickly changing hands, that can indicate the sentiment of the economy is optimistic and affect other parts of the stock market, economy, and even inflation.
Say for example you're wondering why home prices are sky-rocketing whether in Seattle, or elsewhere. As we'll see below in the chart, (although this is not the only reason, but in my opinion is one), there's lots of cash being set aside now and not spent, at least not many times over within a short time-frame, allowing the ability to put more money down for homes.
Add in stock grants tech professionals are vesting along with this available cash , and you've got yourself a highly competitive real estate market, all with "post" COVID-19 remote work accelerating the move further out of metro cities, fueling price growth.
There are two terms you need to know. M1 and M2. These are gauges used by the Federal Reserve - America's central bank - to measure the type of money either being held or spent.
M1: TOTAL of all money HELD (this is key) by people as well as cash deposits in institutions, like banks.
M2: Including all the above, + money in savings accounts and money market mutual funds (less risky, more liquid investment accounts, which are essentially cash accounts that pay a higher interest rate but not generally guaranteed).
What does it mean? The Federal Reserve categorizes the gauge of money supply from narrow (M1 – cash on hand, meaning only looking at essentially one thing - cash in your "pocket"), all the way to more broader terms (M2, MZM money available but not readily), as we just described above.
Comparing the speed of M1 and M2 provides some insight into how quickly the economy is spending and how quickly it is saving to gauge the overall health of the economy.
High velocity of money (M1/M2 gauge is typically > 2.00) in other words, economy is good and expanding (but less savings).
Low velocity of money (M1/M2 gauge is typically < 2.00) in other words, economy is contracting or could be in a recession (but more savings).
So, where are we NOW? My intention is not to get technical, but rather illustrate the changing levels of M1 & M2 (remember this is the gauge being used of cash in folks' hands and money in savings or other not so readily available accounts) looking back 60 years, up until now.
We can clearly see (taking into consideration the COVID-19 pandemic), the levels of BOTH M1+M2 money changing hands fell way down to below 2.00 levels. This is most apparent for M1 gauge (red). So, right now we can see how volatile these levels have been so far, perhaps shedding some light as to whether we as a society are "slinging" cash around or "hanging" onto it.
My last note on this, (it's solely my own opinion, and not of the firm's) is since we've seen the red line shoot way down, meaning people are not necessarily spending money (at least not many times over within a short time frame) on other goods or services, but rather setting it aside, this has arguably given way to a boon for real-estate housing prices to increase.
Hence, more money for a down payment or renovation plus couple that with record low interest rates and here we are, where a "move-in" ready single family home in the desirable east-side of the Greater-Seattle area is approaching $1.3-$1.5 million!
So now we know what the speed of money changing hands means, and we've been able to apply it into the real-world. Hope you found this helpful, and thank YOU for reading!
As always, we put YOUR interests first, as being your trusted fee-only fiduciary advisor. If you would like to learn more about how we work with clients and how we're different, please don’t hesitate to reach out.
Robert Tolstykh, CFP®
*Federal Reserve Bank of St. Louis, Velocity of M1 Money Stock [M1V], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/M1V, August 12, 2021.
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