What Does Money Say About Recession?

John C. Williams, president and CEO of the Federal Reserve Bank of New York speaks to the Economic Club of New York in the Manhattan borough of New York on March 6, 2019. Lucas Jackson/Reuters

Commentary

Both the Federal Reserve and the European Central Bank should have just raised their policy rates while the recession is coming near to the brink. According to a model prediction from a ten-year less three-month tenor Treasury yield gap, the implied U.S. recession probability by yearend already stands at 65 percent, reaching the second highest implied record after that in the early 1980s. From the past half century’s experience, any implied probability above 35 percent would end up in a recession. In this regard, 65 percent probability is essentially not much different from 100 percent!

However, many aspects of the data do not exhibit any symptoms of recession: From the stock market to the housing market and from the labor market to the consumer market. Nevertheless, these coincident indicators would not display any bad trend until a domino effect starts. But some fundamentals can still tell the status, especially the expansionary measurements. As recessions are generally worsened by credit deleveraging, a shrink of monetary expansion before a recession can help narrow the exact time of arrival.

To see this, we can chart those fundamentals with recession periods and then examine them. The monetary expansion involves two stages: One is from narrow money (monetary base) to broad (M2), which is the process of money multiplier augmentation, and another is from broad money to the economy (economic transactions), which constitutes money velocity. The first part is more related to banking as it involves the recreation of deposit lending. In contrast, the second part is due more to general firms as it discusses the linkage between money and the economy.

From the year-on-year (YoY) growth of money multiplier and money velocity, as shown in the accompanying chart, one can see money velocity growth is more prone to come down under recession than money multiplier growth. That says, the red line is more likely to fall than the blue under the grey area. In other words, the firms have more decisive power than the banks in shaping a recession. Think twice; then, you should not be surprised by this: banks merely facilitate firms. Banks are not supposed to have much value-added, but firms are.

Illustrations of U.S. Money Multiplier and Velocity Under Recession. Courtesy of Law Ka-chung

Another interesting observation from the two series is they do not necessarily commove. That is, high growth in money multiplier does not imply the same in money velocity, and vice versa. In the money printing era like the 1970s, money multiplier growth tends to be higher. But in the true boom episode like the early 1990s, money velocity growth tends to be higher. Looking back on the past decade, it is obvious that money velocity growth was much faster than velocity, suggesting a boom more centered in the banking circle than the whole economy (all firms).

Now that both are strong, is this time different? We must be cautious about the low base of money velocity growth a year ago, thus boosting up the latest number. And a current high growth of the two may mean a downtrend ahead, coinciding with a prediction that recession will happen towards yearend.

Views expressed in this article are opinions of the author and do not necessarily reflect the views of The Epoch Times.