One of the reasons the Fed has justified cutting interest rates is the lack of inflationary pressures in the domestic economy. Indeed, core PCE has averaged just 1.6% over the past decade, below the Fed’s 2% target. However, it may soon find a few rate cuts to be unsuccessful in pushing prices higher. The reason being, the Fed does not have complete control over the drivers of both inflation and overall growth. Nominal GDP is a function of both the money supply and the speed at which that money circulates around the system, also known as velocity. When the Fed cuts interest rates, it is attempting to boost growth and inflation by influencing the money supply (an interest rate cut makes loans less expensive, and banks increase the money supply by extending credit to meet this new demand). But the Fed cannot control the velocity of money, which as shown, has been declining steadily for several years.

One of the reasons the Fed has justified cutting interest rates is the lack of inflationary pressures in the domestic economy. Indeed, core PCE has averaged just 1.6% over the past decade, below the Fed’s 2% target. However, it may soon find a few rate cuts to be unsuccessful in pushing prices higher. The reason being, the Fed does not have complete control over the drivers of both inflation and overall growth. Nominal GDP is a function of both the money supply and the speed at which that money circulates around the system, also known as velocity. When the Fed cuts interest rates, it is attempting to boost growth and inflation by influencing the money supply (an interest rate cut makes loans less expensive, and banks increase the money supply by extending credit to meet this new demand). But the Fed cannot control the velocity of money, which as shown, has been declining steadily for several years.

Velocity of M2 money supply

Ratio of quarterly nominal GDP to quarterly average of M2 money supply

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Source: Federal Reserve Bank of St. Louis, BEA, FactSet, J.P. Morgan Asset Management. Data are as of August 12, 2019.