US stocks continued to take it on the chin last week. Amidst this rout that began early October, small-caps last week performed relatively better. Bulls hope this is a signal, not a noise, at least near term.
US M2 money velocity continued to inch up in 3Q18, but from a very suppressed level. At 1.455, it rose from 1.434 in both 2Q/3Q last year, which was the lowest in recent history (Chart 1). Velocity – a ratio between GDP and money supply – measures the turnover of the money supply. It is the rate at which people spend money. If velocity is rising, that means more transactions are occurring between individuals in the economy.
Historically, M2 velocity has shown a tendency to turn up mid-cycle. But in a lot of respects, this cycle has been like no other. Macro bulls sure hope history repeats itself and the recent uptrend continues. But it is too soon to conclude (1) if this continues, and (2) even if it does, it will mean the same as it did in the past.
Post-financial crisis, the Fed aggressively loosened monetary policy, pushing the fed funds rate to near zero in 2008 and keeping them there until 2015. It also launched quantitative easing (QE). The central bank’s balance sheet grew from sub-$1 trillion to a high of $4.5 trillion in January 2015. It currently stands at $4.1 trillion.
In the meantime, M2 money supply increased from $8.4 trillion in June 2009, when Great Recession ended, to $14.3 trillion this October, for a 69.3-percent rise. Nominal GDP between 2Q09 and 3Q18 rose 43.9 percent.
A lot of the QE money is sitting idle in excess reserves. The Fed began paying interest – currently 2.2 percent – on these reserves in 2008. Banks currently hold $1.7 trillion worth. Reserves rose as high as $2.7 trillion in August 2014; six years prior to that, they were sub-$2 billion.
Thus, the velocity signal this time around may not be as clean as in the past. Even if it rises in quarters to come, it may be because the Fed’s balance sheet has begun to shrink. In October last year, the Fed began its QE unwind. Beginning this October, the balance sheet is scheduled to shrink by up to $30 billion in treasury securities and up to $20 billion in mortgage-backed securities. As of last Thursday, the bank held $2.1 trillion in Treasury notes and bonds, down from $2.3 trillion in October 2014 (Chart 2). In the meantime, the fed funds rate has had eight 25-basis-point hikes in the past three years, to a range of two to 2.25 percent.
