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The Fed's Conundrum: It's All About The Velocity of Money

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September 20, 2016
Federal interest rate hike could be good for financial markets.

Could this week's meeting of Janet Yellen and team be a snore? Maybe. Financial markets are pricing in only a 20% chance of an interest rate hike on Wednesday afternoon at 2:00 PM ET. However, that doesn't mean traders and investors should tune out. 

Wall Street analysts will be watching for a change of language in the Fed's policy statement. "It could become a bit more hawkish," says JJ Kinahan, chief market strategist at TD Ameritrade. Kinahan doesn’t expect the Fed to hike short-term rates this week and he points to the December meeting as the next likely time for an interest rate increase. 

Rewind to January of this year and traders will remember the Fed was telegraphing expectations for three or four rate hikes this year and to date, none have emerged. "The Fed is likely to want to get in one rate hike this year to save face and credibility," Kinahan says. 

What this might mean for markets: "If they change the language, it could be good for financials. We've seen over the last week that they have rallied," Kinahan says. Financial companies, including banks, can benefit from a rising interest rate environment as they can profit from the rising spread between deposit and lending rates. 

The Speed Of Money Movement

One of the reasons the Fed has been reluctant to hike rates this year is the slow pace of money velocity. The velocity of money simply refers to the speed at which money changes hands in the economy. "The faster the turnover occurs, the greater the likelihood of rising inflation," explains Sam Stovall, managing director at S&P Global Market Intelligence. 

The Fed's preferred inflation gauge, personal consumption expenditures, remains below the central bank's 2% target, with the most recent reading at 1.6% in July. 

But, another inflation gauge is showing rising prices. The August reading of the core consumer price index (CPI) revealed a 2.3% year-over-year increase. By some historical measures, the Fed is behind the curve. 

Stovall crunched the numbers and found that since 1953, the Fed funds rate is traditionally 1.4% above the level of core CPI. 

"Based on the year-over-year change in core CPI, the Fed funds rate should be at 3.7% right now," Stovall says. The current Fed funds rate remains at an unprecedented and historical low of 0.25%-0.50%. 

The Fed has tried mightily in recent years to stimulate some inflation in the economy, flooding the financial system with liquidity through quantitative easing, balance sheet expansion, and ultra-low, near zero-interest rates. 

"Just because [former] Fed chairman Ben Bernanke flooded the economy with low interest rates, it did not mean inflation would pick up. The money is readily available, but people actually have to use it in the form of loans to lead to a pick-up in money velocity," Stovall says. 

In the meantime, while this week's Fed meeting could be another non-event in terms of a rate increase, it could be received well by the stock market. If the Fed does indeed hold pat on monetary policy this week, "the stock market will likely respond favorably and recover from the latest dip," Stovall says. 

TD Ameritrade clients can follow the progress of money velocity via the FRED charting capabilities now available on the thinkorswim® platform. The chart in figure 1 is of Velocity of M2 Money Stock dating back to 1959.

FIGURE 1: VELOCITY OF M2 MONEY STOCK.

The velocity of money has been dropping since the late 90’s. Data source: FRED. Image source: the thinkorswim® platform by TD Ameritrade. Not a recommendation. For illustrative purposes only. Past performance does not guarantee future results.