Why Money Changes Hands Much Less Frequently
IINFORM A CUSTOMER “I’m sorry, I can’t give you your money” is a banker’s nightmare. But in June, the Federal Reserve had to tell the commercial banks exactly that: it was running out of reserve money. As parts of the economy shut down, the flow of coins from wallets to deposits clogged, leading retailers and banks to demand more. The Fed was forced to ration supplies of pennies, nickels, dimes and quarters based on previous bank orders.
The speed at which money, both physical and digital, moves is an important indicator of economic activity. The “velocity” of money is calculated by dividing the quarterly value of a country GDP by its money supply this quarter. The Fed tracks velocity for several definitions of money. The measure most favored by economists is the “zero maturity currency” (MZM), which includes assets redeemable on demand at face value, such as bank deposits and money market funds. The largest GDP is relative to the money supply, the higher the velocity.
The speed has dropped this year (see graph). In the second trimester, the speed of MZM fell below one for the first time, meaning the average dollar traded less than once between April and June. The decline stems from both economic shutdowns and heightened uncertainty at the start of the pandemic, as well as a significantly increased money supply from stimulus efforts.
Recessions tend to dampen the velocity of money by increasing its appeal as a store of value relative to alternatives. Uncertainty drives up demand for money, says David Andolfatto of the St Louis Fed. In a weakening economy, consumers would rather save than shop; investors cling to the safe assets that make up MZM.
Both the Depression and the Great Recession began with sharp drops in velocity. Where it recovered to pre-depression levels in the mid-1930s, however, the speed continued to decline after the 2007-09 crisis. Some economists attribute this to the Dodd-Frank Act, which took effect in 2010 and put regulatory pressure on shadow banking, increasing demand for money to be held in the formal banking system.
As covid-19 spread earlier in the year, anxiety over the economy caused the speed to plummet further. In April, personal savings hit a record 33.6% of disposable income, not only because of worries about the future, but also because shutdowns have limited the ability to spend. October’s rate of 14.3% was still higher than any pre-pandemic month since 1975.
Meanwhile, stimulus measures have pushed up the money supply, to keep the economy and inflation from falling off a cliff. Households received checks for $1,200, unemployment benefits were made more generous, and the Fed bought public debt with new money. The inventory of MZM jumped by more than 20% between March and June.
The glut of dollars could create a new set of difficulties once the pandemic is over. Households, with sufficient liquidity, could embark on unbridled spending. As consumer demand picks up, more money will start to change hands and inflation will start to rise. Although price support is part of the reason the Fed is buying assets in the first place, some economists worry that the situation could quickly spiral out of control if households all try to spend their money at once. Rutgers University’s Michael Bordo predicts “greater risk of inflation skidding than the Fed is even prepared to consider.” If the speed of money rebounds after the pandemic, putting a speed limit on it may prove as troublesome as reviving it. ■
This article appeared in the Finance and Economics section of the print edition under the title “Change Down”