From the Federal Reserve’s definition of Money Velocity and Money Supply,
The velocity of money is the frequency at which one unit of currency is used to purchase domestically- produced goods and services within a given time period. In other words, it is the number of times one dollar is spent to buy goods and services per unit of time. If the velocity of money is increasing, then more transactions are occurring between individuals in an economy.
The frequency of currency exchange can be used to determine the velocity of a given component of the money supply, providing some insight into whether consumers and businesses are saving or spending their money. There are several components of the money supply,: M1, M2, and MZM (M3 is no longer tracked by the Federal Reserve); these components are arranged on a spectrum of narrowest to broadest.
M1 is the money supply of currency in circulation (notes and coins, traveler’s checks [non-bank issuers], demand deposits, and checkable deposits). A decreasing velocity of M1 might indicate fewer short- term consumption transactions are taking place. We can think of shorter- term transactions as consumption we might make on an everyday basis.
The broader M2 component includes M1 in addition to saving deposits, certificates of deposit (less than $100,000), and money market deposits for individuals. Comparing the velocities of M1 and M2 provides some insight into how quickly the economy is spending and how quickly it is saving.
MZM (money with zero maturity) is the broadest component and consists of the supply of financial assets redeemable at par on demand: notes and coins in circulation, traveler’s checks (non-bank issuers), demand deposits, other checkable deposits, savings deposits, and all money market funds. The velocity of MZM helps determine how often financial assets are switching hands within the economy.
The Equation of Exchange
Money Supply (M) * Money Velocity (V) = Price level (P) * Real economic output (Q)
Alternatively, Money Supply * Money Velocity = Nominal GDP
M1 money stock is currently at $3.78 trillion (up from $1.39 trillion in Q2 2008)
M2 money stock is currently at $13.96 trillion (up from $7.67 trillion in Q2 2008)
MZM money stock is currently at $15.36 trillion (up from $8.73 trillion in Q2 2008)
M1 money velocity is currently at 5.48, almost the lowest on record
M2 money velocity is currently at 1.44, almost the lowest on record
MZM money velocity is currently at 1.31, almost the lowest on record
Years of QE has caused money supply to grow at an unprecedented pace and there is ample liquidity in the financial system.
One could claim individuals and businesses/private sector are hoarding money instead of spending it. Well on the individual or household side of things we know the savings rate is now close to record lows.
We know banks in the U.S. currently hold close to $2 trillion in excess reserves with the Federal Reserve earning over $25 billion in 2017 (read more here). This means they are being conservative with lending money.
Being conservative in lending means charge-off and delinquency rates remain close to record low levels (read more here).
What does all this mean
Firstly, the general inference that an increase in money velocity is indicative of a strong real economy and a decline in money velocity is an indication of a weak real economy is not true.
Money velocity has declined due to a massive increase in money supply.
Either banks are still being very conservative in lending or there isn’t genuinely much demand for new credit.
More money supply is required to fuel GDP growth with low levels of money velocity. [That equation: Money Supply * Money Velocity = Nominal GDP]
Money velocity is gradually beginning to increase and at the same time the U.S. government is pumping trillions into the economy to stimulate it further, either this must result in higher price levels (inflation) or significant increase in real economic output [Money Supply (M) * Money Velocity (V) = Price level (P) * Real economic output (Q)].
If price levels begin to increase significantly, then Federal Reserve will hike rates at every possible opportunity.