Arcane Economic Indicator Could Affect You

Recently, there has been increasing discussion and debate in the financial community about a concept in economics known as “monetary velocity” (or “MV”). MV is rather arcane and is not something most of us think about every day. But it is important to you and me. Here’s why.

MV measures the turnover or cycling of money within the economy. Economists are interested in how fast money “turns over” within the economy because it provides a measure of how efficiently money is being used to support economic growth. It also tells us something about the behavior of the economy.  MV normally increases in periods of economic growth and declines during and for a while following recessions. The efficiency (or “power”) of money within our economy can have an important impact on both economic growth and inflation.

What is most interesting now is MV has recently been hitting new record lows. The Federal Reserve Bank of St. Louis recently issued data showing velocity of M2 (currency in circulation plus checking accounts and money market funds) declining to 1.58, a reduction of over 30% from levels achieved in the late 1990s and well below the long-term average of about 1.8.

So who besides economists cares about 1.58 or whatever the number is? To the extent velocity is low and remains low, it may imply that money within the economy may not be as effective as it could otherwise be in supporting growth. It is also part and parcel of where we are with our economy now: slow, low spending, low investment, etc. Low MV has a few other implications: in addition to restraining economic growth, it can reduce the effectiveness of monetary policy and it can act to restrain inflation, which remains low. Some economists suspect the low MV we are currently experiencing may be blunting the impact of the Federal Reserve’s recent massive monetary stimulus program (aka “quantitative easing”). Our sense is low MV will be with us for a while due to such factors as demographics, below-average job growth, and a new era of constrained credit.

So much for the economics lesson. How might low MV affect financial planning and investments? To the extent one believes low MV may portend continued slow economic growth, this could support an investment strategy that emphasizes higher portfolio income as well as increased exposure to investments in faster-growing economies and growth stocks that are less reliant on the economy. From a financial planning standpoint, while we can achieve these “tilts” in portfolio investments, we advocate that it be done as part of a well diversified portfolio structured to achieve client goals while minimizing risk (volatility). This can be achieved through exposure to multiple asset classes and favoring sectors that would offer the greatest probability for above average returns.