Explaining the link between Other Deposit Liabilities (ODL) and the velocity of money in the real economy

This article was inspired by a podcast called, Escape velocity with Lacy Hunt. The article is my own internal understanding or deep-dive into this thought provoking podcast. Monetary theory and central banking policy, "ODL" refers to "Other Deposit Liabilities." Which are a component of a bank's balance sheet that includes deposits other than demand deposits and time deposits are a very important tool in understanding the risk tolerance in the banking system. This is because of the impact of ODL on the velocity of money in an economy. In this article I want to try and explain why, it's important to understand how these liabilities can influence the overall circulation of money.

Understanding ODL

ODL, represents funds held by banks that are not demand deposits or time deposits. These liabilities can include things like savings deposits, certificates of deposit, and other types of accounts. When banks hold these types of deposits, they have more funds available for lending and investment activities.?

In this context, ODL represents the perceived risks in the real economy, by the banking system. If we follow the red trend line, in 2008, ODL was below trend, however when the Federal Reserve stepped in, to save the banking system, the perceived risks in the financial system reduced and ODL increased.?

Again, as governments around the world turned on the money printers, the perceived risk in the economy collopsed and ODL, saw a massive spick, increasing lending and investment by banks, in the real economy. This was created by an environment of low interest rates and massive government spending, the additional funds available allowed banks to extend credit to borrowers and businesses. Which in turn meant the increased lending and investment led to more economic activity and circulation of money in the economy. I want to use this article, to explain not only the relationship between ODL and the velocity of money, but to explain the massive drop in ODL and what it's telling us about the risks in the real economy.

Can ODL explain why, given full employment and inflation above target, why central banks are in such a hurry to cut rates.

When the velocity of money is constant, it indicates that money is changing hands at a steady rate. In this scenario, the availability of funds through ODL can support a stable velocity of money by providing liquidity to borrowers, businesses, and consumers for spending and investment purposes. Central banks monitor different components of banks' balance sheets, including ODL, to assess the overall health of the banking system and the availability of funds for lending. The problem for the Federal Reserve, is that the velocity of money, couldn't be any further away from any constant state.

On March 20, 2024, the Federal Open Market Committee (FOMC) released the updated Fed dot plot, which showed a projected 2.25-point interest rate cut by year end 2026. This would reduce the fed funds target rate range from 5.25%-5.50% today to 3.00%-3.25%. But why the hurry to cut? FOMC participants also projected PCE inflation to be 2.4% at year-end 2024 and for 2024 US GDP to grow 2.1%, materially higher than its projection from December 2023. The ODL chart is telling the FOMC, that liquidity in the financial system is drying up and fast, due to perceived risk in the economy by the banking system.

The sharp drop in ODL, in 2022, which can be linked to the mini March 2023 banking crisis, is due to liquidity drying up in the banking system. Remember what the Federal Reserve said, the March banking crisis was due to collateral in the financial system. But it wasn't so much about collateral, but the market value of the collateral on offer. Which is why, SVB and Signature Bank, either failed to or couldn't access the Discount Window.?

Fishers understanding of how risk impacts the economy

In his book "The Purchasing Power of Money, Determination and Relation to Credit, Interest and Crises" published in 1911, Irving Fisher delves into the intricate relationship between money, credit, interest rates, and economic crises. Fisher's insights provide a valuable framework for understanding how risk perceptions can impact economic behaviour and the effectiveness of monetary policy tools.

According to Fisher, “Other things remain unchanged, as the quantity of money in circulation increases, the price level also increases in direct proportion and the value of money decreases and vice versa”. In this context, Fisher proposed the equation of exchange which relates the quantity of money in circulation to the price level, the velocity of money, and the output of goods and services. According to Fisher's equation of exchange:

MV = PQ

Where:

M = Money supply

V = Velocity of money

P = Price level

Q = Quantity of goods and services produced

Fisher's theory emphasises that during times of heightened economic risk, individuals and businesses tend to become more risk-averse. In such situations, Fisher notes that there is a natural tendency for borrowing, spending, and investment activities to decrease as economic agents prioritise safety over seeking higher returns. This behaviour leads to a contraction in economic activity and a slowdown in the velocity of money circulation.

My understanding of Fisher's analysis is that where there is excessive perceived risk, traditional monetary policy tools like Open Market Operations (OMO), the Discount Rate, and reserve requirements may lose their effectiveness in stimulating economic growth. Changes in interest rates or reserve requirements may not yield the desired impact on economic activity as a risk-averse financial system, refrain from taking on additional debt or engaging in investment. This disruption results in a deceleration of economic activity and a decline in the velocity of money circulation, posing challenges for policymakers in supporting economic recovery. The perfect real world example of this, has been BOJ Monetary Policy, since the Japanese asset bubble burst in 1989.

The inversion in the yield curve

When there is an inversion in the yield curve, it means that short-term interest rates are higher than long-term interest rates. This is seen as a signal of potential economic downturn or recession. In a normal yield curve, long-term interest rates are higher than short-term rates, reflecting market expectations of economic growth and inflation.

In the context of the velocity of money supply contracting, a yield curve inversion can further indicate potential economic trouble. When investors anticipate a weaker economic outlook, they move their investments towards safer assets, such as long-term bonds, which drives down long-term interest rates, regardless of and sometimes in spite of Federal Reserve policies.

However, short-term interest rates may remain relatively high due to central bank actions to control inflation or stimulate the economy. As Fisher explained, When the real interest rate is negative, it means the rate being charged on a loan or paid on a savings account is not beating inflation. What the inversion in the yield curve is telling us, is that bond market participants are observing signals of decreasing in the velocity of money in the financial system. Which means two things, increased perceived risk and lower future spending and investment in the economy. That's now go through the empirical evidence, that exposes the two main risks in the economy.

High levels of debt and increased risk

Since the stock market collapse in 1987, we have seen a massive steppening in the yield curve, in the level of debt in the US economy, both at the individual and institutional level. While there was a slight correction in 2008, as a result of financial instability and increased risk, due The subprime Mortgage crisis, that trend quickly reversed.

These three charts together are an excellent representation of the link between ODL and risk that I explained above. During the COVID-19 pandemic, ODL ballooned as government stimulus and a frozen economy allowed consumers to pay down debt. This reduced risk, and ODL ballooned, as a result of the increase in the velocity of money, where MV = PQ.

However this increased inflation, resulted in consumers maximising the credit lines they had available, in order to maintain their standard of living, as highlighted by the massive decrease then increase in consumer debt. Which in turn resulted in a collapse in ODL. As a result of the collapse of the health of the consumer.?

We also need to add to the equation, the increase in the federal funds rate and the impact on borrowers ability to repay their debts. This has exacerbated financial stress and has led to a decline in economic activity, highlighted by the chart below, which highlights regardless of the headline figure, full-time employment in the US has fallen by over 1 million jobs year on year.

What we are seeing in the US economy is high levels of debt and increased risk, which is slowing down the velocity of money in the economy. In an environment of high risk and uncertainty, individuals and businesses become more risk-averse and conservative in their financial decisions.?

This can result in lower levels of investment, reduced consumption, and overall decreased economic activity, all of which contribute to a decrease in the velocity of money. I believe this analysis goes a long way in explaining the Federal Reserve expectations, with regards rate cuts, even though unemployment is relatively low at 3.8% and inflation is above its 2% target. What the Federal Reserve sees is a decrease in the velocity of money due to heightened risk, which is having? negative implications for ODL or the velocity of money in the real economy. Slow money circulation can lead to lower levels of economic growth, reduced investment in productive assets, and potentially prolonged periods of economic stagnation.

Over leveraged consumernbsp;

An increase in home equity loans and a reduction or restriction in credit card debt, as highlighted in the section above, this is compounded by a drop in the personal savings rate, not seen since 2008, which can only be interpreted as a sign of a leveraged consumer.?

Home equity loans involve borrowing against the equity in one's home, which can indicate that consumers are leveraging their home assets to access additional funds. While in on itself can be a sign of a healthy confident economy. However, as I have already shown, credit card debt is expanding, while at the same time, full-time employment has fallen by over 1 million jobs year on year, which is compounded by the collapse in personal savings rates. This is not a sign of consumers being more cautious, but a consumer struggling to maintain their standards of living.

From the banks' point of view, an increase in home equity loans, is simply a kicking the can down the road exercise. Protecting the unrealised losses from credit card debt and mortgages at interest rates consumers can no longer afford. Home equity loans also have the added value of being considered, by shareholders, as less risky for banks as they are secured against the borrower's home equity. In contrast, credit card debt is unsecured and carries higher risk for banks, especially giving the clear signs consumers are struggling to repay their credit card balances.

Perceived risk in the economy is also shown by banks tightening lending standards and restricting credit access to the real economy in response to broader economic conditions. What we are seeing is huge economic uncertainty and increasing credit risks,as banks become more cautious in their lending practices to protect their balance sheets, as reflected in ODL and the velocity of money in the real economy.

Conclusionnbsp;

I hope I have shown that by examining the intricacies of economic behaviour and monetary policy, it becomes evident that the velocity of money is not solely dictated by Federal Reserve interventions but is intricately tied to the perceptions of risk within the economy. The shift in consumer behaviour towards opting for home equity loans over accruing credit card debt signifies a trend towards risk-sensitive attitudes, prompting banks to recalibrate their lending strategies accordingly. Conversely, an inversion in the yield curve and a contraction in the money supply velocity indicate a challenging economic landscape where caution pervades consumer and business spending decisions.

This interplay between risk perceptions, economic behaviour, and monetary policy measures underscores the complexity of maintaining financial stability in times of uncertainty. As highlighted by Fisher's insights, the velocity of money is not merely a product of policy tools like ODL and the deposit multiplier but is intricately linked to how individuals and businesses navigate changing risk landscapes. We are clearly seeing an economic environment characterised by heightened risk perceptions, the effectiveness of traditional policy measures diminish, necessitating a nuanced approach that considers the psychological underpinnings of economic decision-making.

In conclusion, the velocity of money serves as a barometer of economic risk sentiment, reflecting how individuals and businesses adjust their financial activities in response to prevailing uncertainties. Understanding and responding to these shifting risk perceptions are essential in crafting effective monetary policy frameworks that can underpin financial stability and promote economic resilience in an ever-evolving economic landscape.