Demand for money; what went up will soon come down

Chart #3 shows the inverse of Chart #2, which can be thought of as the number of times a dollar is spent every year—a proxy for the velocity of money. People today are holding on to their cash like never before. 

So M2 has gone way up and GDP has gone way down because the forced shutdown of the economy has caused the demand for money to soar. That’s completely natural and predictable. The Fed has done the right thing by expanding the supply of money in order to accommodate the increased demand for money. The fact that inflation expectations, the dollar, and industrial commodity prices have been relatively stable for the past six weeks confirms that the Fed has accommodated soaring money demand, and has NOT been madly printing money. I’ve made similar arguments quite a few times in the past on this blog. Quantitative easing is NOT stimulus, it’s a badly-needed remedy for a huge increase in the demand for money. 

But what comes next? With increased signs that the economy is reopening and activity is increasing, it’s quite likely that the demand for money will begin to decline as confidence slowly returns. Money that has been socked away in bank accounts is increasingly going to be spent on goods and services. Will the Fed be able to reverse its QE4 efforts in a timely fashion? Will the public’s desire to reduce their money balances lead to rising inflation?

I won’t be surprised to see restaurants reopening with higher prices on the menu. The government will mandate that the supply of restaurant tables be limited (e.g., maximum occupancy rates of 25% and maybe 50%) at a time when many consumers with pent-up demand will be seeking tables. When demand exceeds supply, higher prices are almost inevitable. Especially since few if any restaurants can be profitable at much lower occupancy rates than they have enjoyed in the past—occupancy mandates will force restaurants to raise prices.

But not everything will be supply-constrained. Airlines are going to have a huge surplus of seats for a long time. Hotels will have a vacant rooms galore. Malls and stores won’t be full until the fear of contagion and crowds disappears. But we are already seeing positive signs of improvement which are quite likely to continue.

We’ve seen the worst of the covid-19 crisis. Looking ahead, the 800-lb gorilla that will dominate the economic and financial landscape for the balance of the year will be the need for the Fed to begin to reverse its massive monetary expansion of recent months. Curiously, I see many analysts worrying that a Fed reversal will jeopardize the recovery. On the contrary, I think it would be very worrisome if the Fed did not realize that they need to “tighten” as the demand for money begins to decline.