Email of the day - on the velocity of money
Comment of the Day

May 23 2021

Commentary by Eoin Treacy

Email of the day - on the velocity of money

Dear Eoin, I hope that your move has gone well. In this article the author argues that it is the velocity of money rather than the quantity of money that influences stock market prices. What do you think of this? Regards

Eoin Treacy's view

Thank you for this article which may be of interest to subscribers. Here is a section:

What is really happening is that all the additional money sloshing around makes people want it less, relative to stocks, and the increased relative demand for the stocks forces share prices up. That’s how QE affects stock prices (or one way it does; other people, especially central bankers, prefer stories about QE lowering the discount rate, on which more shortly.)

Eric Barthalon, global head of capital markets research for Allianz Research, notes that this process is self-limiting. As equity prices rise, the weight of cash relative to equities in investors’ portfolios goes down to a level where the investors are happy. Investors stop trading so much, and prices stabilise. In this story, it’s not the Fed simply stuffing the markets with cash. There is an intermediary factor: investors’ relative preference for cash. 

Barthalon’s argument — I find it pretty convincing — is that (a) investors preference for cash is not stable and (b) the Fed is not in control of it at the moments that matter, that is, when markets are falling. You can track investors’ unstable preference for cash by looking at the velocity of money, or how much it changes hands. Barthalon told me: “It is not the quantity of money but its circulation that causes asset prices to rise or fall . . . and historical experience shows us that central banks do not control the velocity of money, especially in capital markets.”

This is an interesting concept. Looking at the velocity of money as it passes through the financial markets is a difficult thing to calculate, much less monitor. However, it does make sense that the more money trades hands inside the markets, the greater the appetite for risk.

I think it is important to highlight that what is being discussed here is not, as far as I understand, velocity of money in the broader economy. In either case central banks do not control how people deploy their cash. They only control the supply and the cost which can be adjusted in such exaggerated ways to create demand.

That is also the most compelling reason for why central banks are so interested in creating digital currencies. They would instantly have access to granular data on how money changes hands and would have many more levers to pull in how it is spent. The question of personal privacy is almost prosaic as this trend develops.

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