What is the relationship between interest rates and money velocity? Let’s look at two graphs courtesy of the St. Louis Fed. The first is the prime lending rate for US banks. The second is the velocity of M2.
Pretty clearly, there is some positive correlation between money velocity and interest rates. When velocity increases, interest rates generally also increase, and vice versa. Thus we have cleared the first hurdle of causation analysis. There must be correlation in order to have causation, and it appears we have some here, particularly during times of economic contraction.
But to draw an unassailable conclusion of causation between money velocity and interest rates, we would need to do something that is very nearly impossible and rule out any other variables that might collectively cause these two variables to move in lockstep. One thing that jumps to mind here is, of course, the US Federal Reserve.
The Fed effectively sets the interest rates that we are considering here, as the bank prime lending rate is always a direct function of the Federal Funds rate. Prime rates move in direct, positive correlation with Fed Funds rates, meaning that if the Fed Funds rate changes, then the prime rate moves in the same direction by the same amount. We could have instead used the Fed Funds rate to examine the relationship between money velocity and interest rates and reached much the same conclusions as we might reach using the prime rate as our proxy interest rate.
Knowing that the Fed is the immediate causative factor behind the interest rate changes being examined here, and that there appears to be a time lag between a change in money velocity and an interest rate change, the question then becomes whether Fed action follows money velocity, or if it happens the other way around. It’s not altogether clear, but there seems to be a slight time lag between changes in money velocity and changes in the prime rate. Money velocity seems to precede changes in the prime rate, so perhaps the Fed is reacting to changes in money velocity when it changes the prime rate.
But money velocity is not part of the Fed’s dual mandate of stable prices and full employment. If they are targeting money velocity, they are doing it by proxy. What might be the Fed trigger, instead of money velocity? Perhaps it is inflation. But the following chart would suggest otherwise:
Money velocity has bounced around with economic performance, rising when the economy is expanding and falling when it is declining. If we accept the Consumer Price Index as a reasonable proxy for inflation, i.e., for monetary devaluation, inflation has steadily risen over the last forty years, through expansions and contractions, only once declining, which happens to have occurred in the recent contraction. The Fed can’t be using inflation as a proxy for money velocity targeting through interest rate policy. No matter what the Fed does with interest rates, prices keep rising, sometimes more quickly than others, but the history is one of generally increasing price levels, at least since 1970.
Perhaps the Fed is targeting employment levels:
Total employment levels seem to have some limited positive correlation with money velocity and interest rates set by the Fed, at least on the negative side. Generally speaking, when overall employment levels decline, the prime rate will also decline, as will money velocity. Interest rates and money velocity appear to be more heavily affected by whatever causes employment levels to decline. Only a slight change in employment yields a steep change in interest rates and money velocity. Looking very carefully, it appears that declines in employment and declines in interest rates appear virtually simultaneously. The correlation does not hold during non-recessionary periods. I
ncreases in employment levels appear to be profoundly more stable than are interest rates during expansions. Interest rates are all over the map during times of increasing employment, but money velocity generally increases along with employment levels. Both steadfastly decline during times of decreasing employment levels. Thus it appears we have a partial, positive correlation. If the Fed is targeting employment levels with its interest rates, it only succeeds in establishing a correlation during times of declining employment. The rest of the time, the policy seems to have no correlation, and therefore have little or no impact. Money velocity is more tightly correlated to employment levels than are interest rates, and both are tightly correlated to economic performance.
Some conclusions we can draw:
1) Interest rates and money velocity have a positive, but not perfect correlation.
2) Money velocity and economic performance are fairly closely, and positively, correlated. The correlation is most pronounced just before, during and just after periods when the economy contracts.
3) Inflation and economic performance show almost no correlation.
4) Employment levels and economic performance are tightly correlated, increasing in lock-step during expansions and decreasing during contractions.
5) Money velocity, employment levels and economic performance together have a fairly high, positive correlation.
6) Interest rates and inflation show very little correlation.
More on all this later.