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Rotblut: Money Isn’t Changing Hands Fast Enough

Monday, 27 Jun 2011 | 11:26 AM ET

Federal Reserve Chairman Ben Bernanke continues to be the enemy of savers. On Wednesday, the Boston Red Sox fan reiterated his belief that interest rates should be kept at rock-bottom levels for an extended period of time. He views this as necessary in order to keep the economy growing.

Part of Bernanke's problem has been his inability to accelerate the pace of money movement, or velocity. Velocity is an economic measure of how many times a dollar is used to purchase goods and services. For instance, if I give you a $100 bill and you put it into your dresser, there is no real velocity. However, if you use it to make a repair on your car and then your mechanic spends the cash on buying a replacement part, velocity accelerates. Thus, there are advantages to sustaining a certain level of velocity.

An example more applicable to the current environment is the housing market.

The National Association of Realtors reported a 3.8% decline in existing home sales and a 4.6% drop in home prices on Tuesday. A homeowner who cannot sell his house, either because he is underwater on his mortgage or simply can't find buyers for a price he wants to sell at, has capital that is stationary. He is therefore unlikely to buy someone else's house, much less spend additional money on items and services often associated with a home purchase. Thus, the capital tied up in the homeowner's current house is not circulated back into the economy, thereby slowing velocity.

How slow is velocity currently? The chart below, from the St. Louis Federal Reserve Bank, shows the long-term trend in M2 money stock velocity. (This is the ratio of quarterly nominal GDP to the quarterly average of M2 money stock. M2 is a broad set of financial assets, including cash held outside of depository institutions, savings deposits, and money market accounts. Nominal GDP is economic growth that has not been adjusted for the impact of inflation.) The gray bars show when recessions have occurred.

As you can see, velocity is at historically low levels. Velocity is, however, just one snapshot of the economy and not a sole indicator you should rely on. However, when you factor in other signposts, a picture of money not changing enough hands is formed. For example, economist Lawrence Yun complained about "overly restrictive loan underwriting standards" in the National Association of Realtors' existing home sales press release. At the same time, U.S. corporations remain apprehensive about spending money, particularly when it comes to hiring, despite having large cash balances.

In simplistic terms, Bernanke's hope is that if money is both cheap and accessible, velocity will eventually increase, thereby spurring growth. The short-term downside of his policy is that bond rates are staying at historically low levels. The long-term danger is that inflation will jump, forcing the Federal Reserve to hike up interest rates. Though the fed Chairman's margin for error is large and he has many detractors, we still don't know what the actual end result will be. Many of you have assumptions, but the future is rarely what we expect it to be.

Charles Rotblut, CFA is a vice president with the American Association of Individual Investors and editor of the AAII Journal.

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