Contribution of low interest rates to the velocity of money

Money supply or “credit” growth isn’t the only determinant of GDP, but the velocity of that money or credit is important, according to Bill Gross.

Historically, lower and lower interest rates have increased velocity and therefore increased GDP. “Over the past 5-6 years post-Lehman, as the private system has created insufficient credit growth, the lower and lower interest rates have increased velocity and therefore increased GDP, although weakly,” noted Bill Gross in his Investment Outlook for July 2016. However, lower and lower rates have lost their efficacy in spurring lending (credit creation) and growth.

What If Low Interest Rates Don’t Result in Increased Lending?

The above chart clearly depicts how lending has taken a backseat over the past few years. The developed world is falling short of the lubricant that greases its economic engine—credit creation.

There are two aspects to this:

  1. Banks aren’t lending enough.
  2. Interest rates are already at ground level, so more lowering of rates isn’t available as a tool to spur lending.

First, the pace of lending by banks across the developed world has declined. Lending, which leads to credit creation, and further lending, which results in the velocity of credit, are both stuck in low gear. The developed world just isn’t lending. With growth stagnating and deflationary pressures mounting, banks and financial institutions have become wary of lending—defaults are on the rise.

Second, with most of the developed world (EFA) (VEA) at near zero or negative yields, the contribution of lowering interest rates to the velocity of money is diminishing. Currently, about 10 trillion of global government credit (TLH) (SHY) (IEF) is priced at a negative yield. Other things remaining constant, we might see negative yields translating to negative growth for economies. “The contribution of velocity to GDP growth is coming to an end, leading to negative growth” exclaimed Gross.

According to the bond king, Jeffrey Gundlach, Negative Interest Rates Are the Definition of Deflation.

Another point worth noting here is that if lower rates have lost their effect on credit creation, then historic relationships of lower rates equating to higher equity prices also break.

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