In the United States, the velocity of money has fallen into a 20-year downward spiral as the Federal Reserve has imposed a multitude of disinflationary policies. The decline has been constant, until the global COVID-19 pandemic hit which further propelled the downturn. This begs the question: what should America expect in the near future? As we approach the second quarter of the year, the velocity of money has only continued to plummet prompting people to wonder whether this may lead to a rise in inflation. Surges in inflation are not likely, the core inflation rate during peak COVID-19 lockdowns fell by 0.4 percent, and the US headline inflation rate remained a negative 1.1 percent. Money velocity rates decreasing serve as a function of the American consumer saving preferences versus spending during the pandemic. It’s important to note that money velocity is constantly changing, and should inflationary pressures start to rise to parallel an economic recovery, the Federal Reserve will taper its balance sheet to prevent excessive inflation.
Money velocity is calculated on a quarterly basis and is a function of calculating the ratio of gross domestic product (GDP) to the domestic money supply: V=PQ/M. In simpler terms, it is a measure of the frequency in which one unit of currency, or “money”, is used in transactions or purchased domestically-made goods or services. Money velocity is constantly changing on a quarter-to-quarter basis, and changes to money velocity infer two main possibilities: how quickly the economy as a whole is growing or shrinking, and the rate at which money supply is increasing or decreasing. As a result, the velocity of money aids economists in predicting the overall strength of the economy, alongside the willingness for consumers to spend money. This year has also seen an increase in money supply; “dollar bills and coins” distributed via the Federal Reserve Bank and U.S. Treasury into the economy, making up the total money available in the U.S. economy at a point in time. This year’s increased money supply and decreased money velocity form an inverse relationship. Coronavirus economic relief efforts aided money supply growth, while fewer transactions were made throughout the economy due to consumer savings increasing from economic uncertainty, ultimately decreasing money velocity. With these changes in the circulation of money available in the U.S. economy, the level of commodity prices changes, according to the quantity theory of money.
Now that we understand the definition, we can begin to unpack what the decrease in money velocity indicates. The last 20 years’ steady decline in money velocity is indicative of a shrinking economy. Furthermore, the rapid drop off of money velocity in 2020 also results in several uncertainties: Will the economy have a further downturn? Is it likely inflation will surge as a function of increasing the money supply? How quickly will consumer spending levels bounce back? In response to the coronavirus pandemic, there have not only been changes in the monetary policy but also implementations of Federal stimulus spending. This has caused the U.S. money supply to grow exponentially amidst 2020, as much as 6.7 percent in April and 5.0 percent in May. This leaves the U.S, with an increase of over 23 percent year-on-year money supply from 2019, almost double the prior peak money supply growth rate. The surging of the money supply growing at a rate higher than an upward-facing economy is the direct result of declining money velocity. Yet, the inverse relationship between increasing money supply growth and declining money velocity is a large red flag for possible future inflationary issues.
Over $2 trillion of stimulus aid was inserted into the U.S. economy this year, which led many to think that inflation rates leading into 2021 will exceed the typical year-on-year inflationary growth. Looking at economic relief efforts, the Federal Reserve was very responsive. Reliefs included purchasing $3.5 trillion in treasuries, corporate bonds, alongside mortgage-backed securities. However, the effects of the coronavirus relief funds are stagnant in regards to the inflation surge. With the United States going on quarantine lockdown, demand amidst many different sectors has decreased, alongside pricing. Spending rates have also decreased as Americans are scared for the unknown future of the economy due to rising rates of unemployment while saving rates have increased to as high as 13.1 percent in early 2020. With the quantity theory of money historically showing that a faster money supply growth than GDP growth leads to inflation, the coronavirus stimulus-response may lead many to think of the long-term implications of inflation (growth of money supply-growth of output).
The International Monetary Fund (IMF) forecasts GDP to grow 5.4 percent in 2021, which would help counteract the negative 3.5 percent loss in real GDP in 2020. A rise in 2021 GDP growth of this stature would lead to excess demand, thus causing high inflation, however with continual re-opening of the economy, the paralleled surge in spending to further stimulate the economy would put inflationary pressures at ease. A quick glance back into the 1957 influenza pandemic can reflect a certain level of correlation to the COVID-19 pandemic. Influenza took the world by storm and affected not only individual livelihoods but also the U.S. economy in a large way. A nine-month recession took place shortly after and inflation actually began to weaken, causing no large surge in long-term inflation levels.
Now, looking forward there is a chance measured inflation may ebb and flow, yet in moderation with supply chain distribution and pent-up demand. However, the real indicator of what inflation will look like moving forward is going to come down to the American consumer’s spending and confidence levels. Further scientific research and the COVID-19 vaccine is a promising indicator to get Americans back out into the economy, increase spending levels, and ultimately juxtapose the long-term thought-to-be implications of money supply growth in 2020 leading to excessive-high inflation.