What Is the Velocity of Money: Inflation or Deflation Clue?

Velocity of Money: Inflation Predictor or Deflation Indicator?

Jan 3, 2025

Introduction to the Velocity of Money

The Velocity of Money (VM) concept might appear esoteric, but it has profound implications for inflation, interest rates, and overall market sentiment. VM measures how quickly money circulates within the economy—how often a single dollar changes hands over a given period. Analysts commonly examine M1 velocity (cash and checking deposits) and M2 velocity (M1 plus savings accounts, money market funds, and other relatively liquid assets). While standard textbooks often describe velocity as “the rate at which money changes hands,” real-world fluctuations in velocity can expose deep truths about whether an economy faces inflationary or deflationary pressures.

Some economists liken velocity to the “heartbeat” of the financial system; when the pulse quickens, money moves faster, often raising the prices of goods, services, or assets. When velocity slows, it typically indicates that consumers and businesses hoard cash or pay down debt, which can stifle demand and suppress prices. This push-pull dynamic can result in periods of exuberant growth—or dismal stagnation—depending on how people and institutions perceive future economic conditions.

A common misunderstanding is that printing more money automatically leads to inflation. In reality, whether inflation materializes depends on the interplay between the money supply and how fast that money is spent. Increasing the monetary base does not force consumers to rush out and buy more; it must be accompanied by a rise in VM to have a truly inflationary effect. This dance between central bank policy and actual spending behaviour lies at the heart of inflation forecasting—and forms the basis of ongoing debates about whether we hover on the cusp of inflation or teeter on the verge of deflation.

VM as an Inflation Predictor—or a Deflation Indicator

Historically, many economists—including Milton Friedman—claimed that “inflation is always and everywhere a monetary phenomenon,” implying that as the money supply grows, so do prices. Over time, scholars refined the argument, emphasizing that the velocity of money must also be considered. If individuals and institutions choose to hold on to their cash instead of spending or investing it, price levels often remain subdued. This phenomenon was starkly evident in the wake of the 2008 financial crisis when massive injections of liquidity did not result in runaway consumer price inflation.

To understand why, one must see that velocity embodies the public’s willingness to part with money. When consumers fear economic uncertainty, they delay purchases. Businesses hold cash reserves and are worried about future revenue streams. If market conditions are uncertain, investors might pile into “safe” assets like treasury bonds. These behavioural shifts reduce turnover in the economy. In effect, the money may sit idle in bank accounts, curbing inflationary pressures.

On the flip side, if optimism is rampant, investors speculate in real estate or stocks, and businesses expand aggressively. Consumers splurge on everything from cars to luxury goods, and money changes hands at breakneck speed. In such an environment, inflation can surge rapidly. Sometimes, VM can rise in asset classes first, causing asset-price inflation before seeping into consumer goods and fueling more traditional measures of inflation such as the Consumer Price Index (CPI). Ultimately, velocity serves as a vital clue to whether an economy will move toward stable growth, an inflationary boom, or a deflationary slump.

2007–2020: Plenty of Money, Slow Velocity

From 2007 to 2020, central banks worldwide—led by the U.S. Federal Reserve—embarked on unprecedented monetary expansion. The intent was to rescue the global financial system through quantitative easing (QE). Banks received giant infusions of liquidity. Observers expected that this “wall of money” would trigger roaring inflation. Yet, inflation remained relatively tame for most of that period, baffling those who hewed to the simplistic model of “more money = more inflation.”

Why the paradox? The short answer: is thatvelocity languished. Rather than rush to lend freely or encourage lending to small businesses and consumers, many banks hoarded the fresh liquidity to shore up battered balance sheets. Those who did lend found mostly large corporations or real estate investors willing to borrow; the average consumer was not quite as enthusiastic, still reeling from job losses and plummeting property values. Unsurprisingly, the money supply ballooned, but it barely circulated fast enough to spark broad-based price surges.

During this time, we did witness asset inflation: stocks soared, and real estate markets in major cities became frothy. M2 velocity rose selectively, propelling commodities and equities. Still, this asset inflation did not translate into immediate CPI spikes. Many households stressed over wage stagnation and kept discretionary spending down. In effect, the economy acted like a dammed-up reservoir of potential liquidity. People noticed the water level rising, but it didn’t flood downstream into everyday prices at nearly the pace one would expect from such aggressive monetary policies. Thus, the missing piece was “Where did the money go?”—the short answer being that much of it stayed locked within the financial system or ended up chasing asset markets rather than daily goods and services.

Post-COVID Era: Direct Stimulus and the Velocity Spike

In stark contrast to the slow trickle from 2007 to 2020, after COVID-19 emerged, governments worldwide—especially in the United States—shifted tactics dramatically. Instead of channelling liquidity primarily through the banking system, they placed cash directly into citizens’ hands. Stimulus checks, enhanced unemployment benefits, and Paycheck Protection Program loans meant that ordinary people suddenly had more money at their disposal. As restrictions eased, consumers, itching to spend after months of lockdown, began fueling a sharp increase in demand.

This direct injection of funds supercharged velocity. Households upgraded living arrangements, bought appliances and furniture, spent on online shopping sprees, and in some cases, invested in stocks or cryptocurrencies. The combination of pent-up demand and actual buying power lit a fuse under prices, culminating in the inflationary surge witnessed in 2021–2022. The phenomenon far exceeded the moderate asset-price inflation typical of the previous decade; it filtered into everyday goods—from groceries to automobiles—leading to the highest inflation rates seen in decades.

Notably, once people perceive money to be losing purchasing power, they tend to accelerate spending even more—a feedback loop that bolsters the velocity of money. Consumers reason, “Better to buy now, before prices go higher.” These behaviours highlight a cognitive bias known as the “bandwagon effect,” where mass psychology drives countless individuals to act in unison, compounding the original trend. Meanwhile, central banks, initially confident inflation would remain “transitory,” found themselves scrambling to adjust monetary policy in an attempt to break an economy already in overdrive.

Using Velocity and Mass Psychology to Time Markets

Market timing is notoriously challenging. Still, patterns in VM—particularly when combined with mass psychology—can offer valuable clues. When velocity lingers at low levels, it typically signals caution. People and businesses remain risk-averse, and asset prices might drift sideways or climb only slowly. However, a sudden uptick in VM often proves a leading indicator: it shows that consumers are shedding caution and that optimistic spending is on the horizon. In such moments, savvy investors might catch the wave early, positioning themselves in sectors prone to benefit from heightened demand or new borrowing initiatives.

On the flip side, velocity surges can become excessive. As the public grows euphoric, an irrational exuberance takes over, reminiscent of the “secret desire to lose” phenomenon where investors chase overpriced assets. They see everyone else making money, so they jump in at—or near—the peak. This bandwagon effect can turbocharge final gains but also sets the stage for a painful crash once the frenzy subsides. Timing such peaks requires a systematic approach, partly due to cognitive biases like FOMO—fear of missing out—and recency bias, where people assume recent trends will persist indefinitely.

Historically, we have seen these cycles in events ranging from the dot-com bubble in 2000 to the meme-stock mania of 2021. One can track the velocity of money metrics, credit growth, and consumer confidence indices. When all three spike, an intense risk-on mentality grips the market. Investors attuned to these signals might trim long positions or tighten risk controls, anticipating that once velocity stalls or declines, a big correction may unfold.

Combining VM, Mass Psychology, and Technical Analysis

While VM can offer macro-level insights, it gains potency when paired with technical analysis and a keen understanding of how crowds behave. Chart patterns, moving averages, and momentum indicators help investors identify entry and exit points. For instance, if velocity begins to rise sharply at the same time stock market indices break through major resistance levels on strong volume, that alignment can reinforce a bullish thesis. Conversely, if velocity drops or plateaus while support levels give way, it might herald a downturn.

Mass psychology further refines these signals. As social media platforms amplify trends and sentiments in real-time, tracking viral hashtags, search trends, or influencer-driven hype can tilt the odds in favour of an investor who anticipates big moves. Suppose the velocity of money starts to flatten, but internet chatter about “guaranteed gains” grows uncomfortably loud. That gap between the fundamental data (velocity) and the narrative hype (psychology) might warn of a looming top.

Cognitive biases often lurk in these transitions, skewing perception. Confirmation bias makes people selectively interpret data that supports their bullish or bearish stance, while the bandwagon effect magnifies groupthink. Recognizing these pitfalls can help investors remain objective. An investor who sees velocity’s slowing pace, even as social sentiment remains euphoric, may decide to scale back positions rather than succumb to the mania. In this sense, synergy arises: technical analysis offers historical chart-based context, velocity data reveals macroeconomic currents, and mass psychology signals whether rational or emotional forces are driving markets.

Examples and Lessons from Past Surges

Consider the 1970s stagflation era, often cited by economists as a prime example of velocity-driven inflation. Central banks expanded the money supply amid oil shocks and geopolitical tensions. Ultimately, pent-up demand and nervous consumers caused prices to climb, reflecting how an uptick in velocity contributed to sharp inflationary pressures. Fast-forward to the 2008 financial crisis: M2 expanded, but fear and uncertainty hammered velocity, muting consumer price inflation and funnelling liquidity into select assets instead (primarily real estate prior to the crash and later into equities).

When COVID-19 struck in 2020, central banks again embarked on massive stimulus, but with a crucial twist: funds were transferred directly to consumers in the form of stimulus checks. This unleashed a sudden spike in VM once lockdowns ended, fueling both asset- and consumer-price inflation. The shift in velocity aligned with mass psychology: stifled demand, combined with looming fears of future price hikes, propelled consumers into buying sprees.

From these historical episodes comes a central lesson: merely printing money does not guarantee higher prices. Velocity is the catalyst that transforms monetary supply into inflation. If the newly created money remains dormant—parked in treasuries or bank accounts—inflation can stay subdued. But once the masses collectively decide to spend, hoard physical goods, or chase speculative assets, velocity rises. At that moment, central banks scrambled to tame the beast while the average consumer grappled with rising living costs, and the investor community scrambled to adapt.

Conclusion and Final Thoughts

Velocity of money stands as a potent—but often overlooked—tool for predicting inflation and even timing market shifts. While central banks can unleash massive liquidity programs, the real inflationary or deflationary impact depends on the public’s psychological inclination to spend or invest that money. From 2007 to 2020, trillions of dollars were pumped into banking systems, yet inflation barely budged, precisely because the velocity of money stagnated. In that environment, economic growth seemed tepid, but asset markets still soared—evidence that some pockets of velocity did accelerate primarily in real estate and equities rather than in everyday goods and services.

After COVID struck, however, stimulus efforts reached ordinary consumers more directly, sparking a broader spending surge. VM shot upward in ways not seen since well before the Great Recession. The backlash arrived swiftly in the form of higher consumer prices, exposing how shifts in mass psychology—driven by real or perceived scarcity, fear of rising prices, or a desire to capitalize on new market trends—supercharged the velocity of money.

Understanding VM, mass psychology, and technical analysis offers a more nuanced framework for market timing and macroeconomic forecasting. Investors who note velocity trends can position themselves before widespread sentiment changes cause asset prices to rocket—just as they can lighten up risk when velocity plateaus yet euphoria remains dangerously high. Meanwhile, an awareness of cognitive biases like groupthink, FOMO, and the bandwagon effect helps any decision-maker avoid becoming another statistic of herd-following gone wrong.

In essence, the velocity of money is about how society perceives and uses currency in real-time. When the collective mood shifts from hoarding to spending or from caution to speculation, it can dictate everything from real estate booms to crypto-mania. Those who learn to read these signals—without succumbing to the secret desire to lose—gain a decisive edge in navigating the chaotic interplay between liquidity, inflation, and market psychology.