Based on M2 Growth, the Dollar Should Be Stabilizing

There has been a lot of discussion and concern lately about the falling U.S. dollar, but not a lot of attention on one of the main factors that ultimately determines the dollar's value in the foreign exchange markets: the supply of dollars.

The chart above shows the weekly M2 money supply plotted against the weekly trade-weighted dollar index for major currencies starting at the beginning of 2008. From the March 11, 2009 peak the U.S. dollar index has fallen by just over 13%, but most of that decline happened from early March to early June (-11%), and since then the dollar has only fallen by a little more than 2% during the last four months. Over the last two months since early August the value of the dollar against the major currencies index (based on the euro, Canadian dollar, Japanese yen, British pound, Swiss franc, Australian dollar, and Swedish krona) has been flat (data are available through October 7).

The M2 money supply increased by 10% in 2008 as part of the Fed's expansionary monetary policy that lowered the Fed Funds rate to almost zero by the end of 2008. From the start of this year, the M2 money supply has been basically flat, growing by only 1.8% over the last ten months. What can we learn from these data? Here are some ideas:

1. The 13% decline in the value of the dollar over the last seven months largely reflects the 10% increase in the money supply in 2008.
2. In 2009, the growth in M2 money supply has stabilized at less than 2%, and this means the value of the dollar will stabilize later this year or by next year at the latest. In fact, this dollar stabilization has already happened over the last several months, with only about a -0.60% decline in the major dollar index since early August.
3. Against the broad dollar index, the U.S. dollar has fallen by only -10.3% from the early March peak versus the -13.1% decline for the major currency index, meaning that the dollar has fallen more against the major currencies than against all currencies in general.

Comments

[jeremiah74:]

" From the start of this year, the M2 money supply has been basically flat, growing by only 1.8% over the last ten months. What can we learn from these data? Here are some ideas:

"The 13% decline in the value of the dollar over the last seven months largely reflects the 10% increase in the money supply in 2008. "

"In 2009, the growth in M2 money supply has stabilized at less than 2%, and this means the value of the dollar will stabilize later this year or by next year at the latest. In fact, this dollar stabilization has already happened over the last several months, with only about a -0.60% decline in the major dollar index since early August. "

well, here are my ideas:
- the velocity of money is slowing because the Fed's balance sheet has still been expanding this year more than what M2 did as you suggest. this doesnt bode well for the advertised V type recovery in the economy (you are also advertising this in many of your articles)

- since you didnt bother to mention what other central banks do with their base money supply, how can you conclude anything about the dollar versus other currencies ??? what kind of analysis is that ??

money supply surely plays a part in a currency's value, but looked at in isolation it can not be considered serious analysis

Oct 16 06:19 AM

[DONE_SONZ:]

Besides M2,what about the mountain of debt?The gig is up on the fiat game.

Oct 16 06:22 AM

[LilBob:]

Mark is generally more bullish than I am but on this point I'm going to agree with him. To me it appears the Obama administration is actively trying to devalue the dollar in an attempt to make American workers relatively more cost effective, thereby-at least-slowing the pace of outsourcing of jobs-if not-eventually leading to a restoration of domestic production. Attempts to devalue the dollar will eventually be matched by other countries seeking to keep their workers competitive as the US is still the ultimate market for goods for many developing nations. Hyperinflation rooted in devaluation of the dollar versus other currencies simply isn't all that likely. Even the creation of a new reserve currency to facilitate transnational commodities trading wouldn't be likely to cause excessive inflation because even though it would likely result in a significant spike in oil prices, the potential for devaluation of the dollar and elimination of many farm subsidies would have an effect similar to when Roosevelt took the US off the gold standard in the 30s, resulting in significant job creation and a massive rebalancing of the trade deficit.

Oct 16 06:36 AM

[flow5:]

Currency crises have primarily been the direct result of an overly restrictive U.S. monetary policy (“when the U.S. sneezes, the rest of the world gets a cold”), e.g., 1987 - at that time, the most restrictive period since 1918 (i.e., if you understand money & central banking).

This same logic also applies to the July/08 until March/09 period (the collapse of the non-banks). That contraction (and illiquidity), required the FED to negotiate "temporary reciprocal currency arrangements (central bank liquidity swap lines) with a number of foreign central banks: (1) dollar liquidity swap lines and (2) foreign-currency liquidity swap lines."

While the dollar's climb beginning Jul/08, and reversal Mar/09 (trade-weighted exchange index: broad), is coincident with the rapid expansion of the money stock, there are opposing forces at work. Bank liquidity, transactions velocity, nominal gdp, and the never ending trade deficit, were all contracting during the dollar's rebound.

Normally, the exchange value of the dollar, and an expansionary rate-of-change in the money stock, both move together (not with a lag). I.e., the FED initiated an "easy" monetary policy beginning Oct/02, by increasing the rate-of-change in legal reserves.

There are other factors, including interest rate differentials (long-term interest rates resulting from monetary flows (MVt) in excess of 2-3 percent of real-growth, as well as inflation expectations). These factors, plus the protracted trade deficit that began in 1985, now exceeds 7.4 trillion dollars (current account balance), deficits initially held as foreign short-term claims. This incomprehensible figure ascertains a continuation of the dollar's decline.

Measure the trade deficit 7.4 trillion dollars against the colossal Federal Budget Deficit which is 12 trillion dollars (again another incomprehensible figure), and we have the ingredients for an economic disaster.

But the major problems don’t end there: As the number of banks participating in Euro-Dollar (or other currencies), transactions increase, the E-D bankers know that the E-D deposits they created for borrowers often don’t result in a diminution of their U.S. dollar balances – the System merely shifts balances within itself. That is, drafts drawn on E-D banks are deposited in other E-D banks. This is the basis of an international system of “prudential” reserve banking – the discovery that the amount of actual U.S. dollar reserves required to support the E-D loans made – and E-D deposits (money) created (another incomprehensible figure).

But money is truly a paradox - by wanting more, the public ends up with less, and by wanting less, it ends up with more. Therefore, if there is a flight from the dollar, there will be hyperinflation in terms of dollar denominated assets.

Oct 16 02:30 PM

[flow5:]

WASHINGTON (MarketWatch) -- THE DOLLAR IS NOT A TOOL THAT U.S. POLICYMAKERS USE Dallas Federal Reserve President Richard Fisher said Friday.

Oct 16 08:54 PM