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Velocity of money is the rate at which money is being spent in the economy. It is calculated by dividing GDP (gross domestic product)(opens in new tab) by the money supply (M1 & M2). Both M1 and M2 can be used for calculation purposes. Think of M1 as the more focused number. This includes cash and transaction deposits, whereas M2 is larger and encompasses savings, CDs and money markets. GDP is the value of all goods and services in the economy.
The faster money changes hands within the economy, the stronger the economy is thought to be. Therefore, if we see a trend in either direction, we can assume that the economy is getting better or worse depending on the direction of the velocity of money, either up or down.
Sometimes the velocity of money can be affected simply by things like rising inflation. During periods of higher inflation, the velocity of money tends to increase. This is why I have been monitoring it more closely this year.
As you know, the Fed has been desperately trying to reduce inflation by raising interest rates in an attempt to slow the economy. One of the ways we check on if its attempts are working is to see if the velocity of money is declining. If not, signs might point to continued elevated inflation.
It’s important to note that the velocity of money isn’t the end-all for measuring the economy. The Fed’s manipulation of its balance sheet changes GDP and therefore the velocity-of-money calculation, which some argue makes the velocity-of-money figure less valuable.
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I would argue a higher velocity-of-money figure does represent a decent picture of higher inflation, but it is somewhat less reliable when it’s falling. This is why other factors need to be considered in order to make an assumption about the direction of the economy.
So, what are my thoughts? I think we will see a recession in 2023, but that it likely won’t be either deep or prolonged. I think the market has already priced this in, and therefore, a recession won’t have much of a negative effect, if any, on the stock market.
