US Velocity of Money Hits a 40 year Low: What Determines Interest Rates Now?

The following graph from Bloomberg shows the dramatic collapse in the demand for money in the US.

The image shows the behaviour of the US velocity of money as measured by M1 from 1970 to the present. Velocity is a critical determinant of the price level since it measures the number of times money in circulation is spent on goods and services. Rather than spending the money that the Fed has injected into the system, the private sector has simply decided to reject the cash that has been thrown at them with QE. Velocity is now at a 40 year low – US consumers and businesses simply cannot be forced to spend cash like lemmings.

For practical purposes, this is big news. For one thing, low and falling demand for money renders the Federal Reserve redundant. But the main impact is that interest rates no longer contain an inflation premium. Accordingly, interest rates can permanently settle at lower levels, commensurate with their real sector determinants.(1)

Could financial markets be gravitating toward a world with overall lower interest rates that fluctuate with economic activity and investor risk aversion? If so, there would be some predictable effects. First, and contrary to popular belief, a cyclic increase in economic activity would drive future interest rates lower in order to encourage consumption rather than saving. Second, an increase in risk aversion would cause short term interest rates to rise and the price of risky assets to fall.

Does a world with lower overall interest rates, which fall when economic activity accelerates and which rise when investors panic sound familiar?

Footnote
(1) How does this work? I have noted in earlier posts that it is very difficult to get money into a general equilibrium model of economic activity. The common method is to impose a ‘cash-in-advance’ constraint which requires agents to hold cash (denoted M) for future purchases (PY is price times output), so that M=PY. In this world, the interest rate is expressed as, R = Inflation x Real Stuff, where Real Stuff is made up of technological factors and investor preferences.

What happens if agents decide they don’t want to hold cash? In this new world, the cash-in-advance constraint no longer binds so that M > PY and interest rates are simply given by R* = Real Stuff. It can be shown analytically that R* < R which means that interest rates in the new cash-less world are LOWER than in the world where money was needed to exist.