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RC-2022.01-Money-Velocity_1380x467
18.01.2022

Money and its velocity matter: the great comeback of the quantity equation of money in an era of regime shift

Published 

18 January, 2022

> 10 minutes
18.01.2022
Money and its velocity matter: the great comeback of the quantity equation of money in an era of regime shift
Published 

18 January, 2022

> 10 minutes

ABSTRACT


The velocity of money (V) depends on P = the general price level, T = the total amount of goods and services produced and M = the total amount of money in circulation, and can be expressed by the formula V = PT/M.

Since the late 90s, the velocity of money has continued to fall and the Covid-19 crisis has exacerbated this trend, reflecting a low level of activity, together with monetary and budgetary support. At the same time, the velocity of money in the financial sphere has trended higher, as reflected by increases in asset prices.

However, if we consolidate the financial and real spheres into one unique notion of V, the velocity of money looks higher than traditionally measured.

In the next sequence, we expect that excess liquidity will be absorbed and that prices for goods and services will increase. 

Longer term, however, a regime shift will materialise. This will be characterised by governments taking over control of money while maintaining widespread and double-digit monetary growth for several years, as part of a broader transition from free market forces, independent central banks and rule-based policies to a command-orientated economy. Additional money creation, for example to finance the energy transition, could build the conditions for a simultaneous financing and expansion of both the financial and real spheres and will lead to an increase in asset prices and in the prices of goods and services for at least some time.

This scenario could introduce another lag between rising inflation and low interest rates, as rates would be capped for some time (resulting in financial repression), before the authorities lose control of yield curves, thus leading to a new monetary order (another feature of the new regime).

In addition, inflation have a critical psychological dimension that could have significant implications on money and its velocity and their impact on activity, prices and interest rates. Powerful forces of memory and forgetfulness drive the psychological sphere. Short-term memory exerts a persistence effect (for example the recollection of secular stagnation could have led to the underestimation of inflationary persistence in 2021), while forgetfulness has its highest influence at both the top and the bottom of cycles. As inflation proves more persistent and disinflation/deflation memories fade, market attention will return to past inflationary episodes, such as the ‘70s.

This process is not linear; it can be brutal at times and self-sustaining. In a regime shift, characterised by deviations from a “normal, reference, stable” environment, there can be a rapidly increased focus on the most recent data and to confirm any divergence from previous patterns. This is precisely where we are today with inflation. At some point in time, the forces of money and the relevance of the monetary equation will come back into focus, but this will come with a loss of control and credibility for central banks. This will be the time when the regime shift becomes a reality and will determine a reordering of risk premia.

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