Money Velocity and Its Impact on Inflation

by Trent Wiseman | October 31, 2024

As 2024 draws to a close, financial markets are reflecting several critical trends, including dollar stability, shifts in money velocity, and evolving commodity ratios, all underscoring the complex economic landscape going into the new year. Central banks are globally maintaining a tight focus on inflation expectations with the global interest rate cutting cycle in full swing.

Currency Trends and Dollar Resilience

The dollar index (DXY) has remained within a range between 100 and 107, and the euro has struggled to break through the 1.12 resistance level. This reflects a polarized outlook on the dollar’s strength. On one side, the U.S. economy remains strong, with U.S. bond yields; peaking at 4.7% in 2024 before settling at 4.1%, among the highest in the G10 countries. High real bond yields have bolstered the dollar, attracting global investment.

On the other side, concerns about an overvalued dollar and potential disinflationary forces cast doubt on sustained dollar strength. If U.S. growth slows and inflation falls short of expectations, bond yields could decline, initially putting pressure on the dollar. 

The Role of Money Velocity in Inflation and Interest Rate Trends

Money velocity (V), a critical metric that links money supply to economic output, is once again influencing inflation and interest rates. V is calculated as follows: 

where P is the level of prices in the economy, Q is economic output and M is money supply.

Historically, money velocity provided insights into liquidity conditions, with rising velocity typically signalling economic growth. However, money velocity has recently decelerated in the U.S., especially when compared to Europe (figure 1), signalling a call for easier monetary policy. Even with this deceleration, U.S. money velocity remains higher than in other countries, suggesting that the U.S. economy might require relatively higher interest rates to maintain stability, in line with its persistent inflation resilience.

figure 1

U.S. and Eurozone Divergence

A clear divergence has emerged between the U.S. and Eurozone economies. With money velocity falling in the euro area, the European Central Bank (ECB) has adopted a more dovish stance to stimulate economic activity. Eurozone core inflation has slowed, leading to higher precautionary savings and weaker growth. This slowdown has pressured the euro, with German yields trending lower than their U.S. counterparts. The expected outcome is a continued fall in German yields and a decline in the euro, which may aid European exports in the long term.

Japan and Other International Perspectives

Japan presents an interesting case where rising money velocity, alongside a high worker savings ratio and undervalued yen, indicates strengthening demand and rising interest rates. This environment supports a bullish outlook for the yen. Money velocity in the UK and Switzerland are on the same path with both nations exhibiting declining money velocity, suggesting softer inflation and economic activity.

The Gold/Silver Ratio (GSR) 

Another key indicator for providing insights into global economic conditions is the gold/silver ratio (GSR). The GSR often mirrors the relative velocity of money between the U.S. and China. When the U.S. economy outperforms China’s, the GSR tends to rise, reflecting stronger demand for gold as a safe-haven asset over silver, which is more industrially linked to China. Given current U.S. economic resilience and a cooling Chinese economy, the GSR is expected to rise toward 90, signalling favourable conditions for gold over silver in the near term.

However, there are two headwinds facing the GSR. First, the ratio is historically expensive, at the highest levels since the COVID-19 pandemic. Second, silver’s physical deficit has been increasing with production levels last seen in 2012 (figure 2). 

figure 2

Conclusion

As 2024 concludes, financial markets highlight significant macroeconomic trends, from dollar resilience and interest rate fluctuations to diverging economic paths between the U.S. and Eurozone. The behaviour of money velocity, both in the U.S. and globally, continues to shape inflation and monetary policy expectations, with central banks maintaining a careful watch on inflation dynamics and economic output. Commodity ratios, such as the gold/silver ratio, further underscore evolving global conditions, with shifts in economic strength between the U.S. and China reflecting broader geopolitical and financial shifts.

At wauko we work with our clients to formulate and manage a comprehensive foreign exchange risk management policy. We will gladly assist you with your process to help you do more and grow more. Contact Dale Petersen on 021 819 7802 or at dpetersen@wauko.com to connect with us.

Reference

  1. BCA Research – The Case For V – 18 October 2024

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