Thursday, October 15, 2009

Based on M2 Growth, The $ 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.

9 Comments:

At 10/16/2009 3:06 AM, Anonymous Anonymous said...

This analysis is flawed for two reasons. One you are only factoring in supply of currency, what about demand which is variable and has just as big as an effect. Second, comparing one floating currency to another floating currency is ridiculous to put it nicely. Currency A can be devalued at 10% Currency B at 20% and yet it would look like currency A is strengthening 10%. The answer would be no, they are just be devalued at different rates.

 
At 10/16/2009 6:34 AM, Blogger BMWright said...

Interesting information. "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". One would have to question this conclusion due to the fact the dollar was soaring in Q4 when the money supply was increasing. Purhaps it has more to do with the end of world wide financial panick and a return to US debt and inflation worries.

 
At 10/16/2009 7:45 AM, Anonymous Anonymous said...

That chart does not communicate any clear correlation between M2 money supply and the value of the dollar to my layman's eyes, at least not in the short term.

I think we haven't had any inflation to speak of because the dollars we are printing are still backed by Treasury Bonds purchased by foreign governments.

However, when Social Security begins running a deficit next year, we will have to start paying Social Security benefits from the Social Security Trust Fund. Unfortunately, the Social Security Trust Fund has already been spent and consists only of Treasurty Bonds held by... the US Government.

It is illegal for foreign governments to purchase intra-governmental bonds, so is it wrong to think we will truly be engaged in Zimbabwe-like money printing next year?

 
At 10/16/2009 7:50 AM, Anonymous Anonymous said...

As you know, P=MxV, that is, price equals money supply times velocity.

During the credit crisis, velocity disappeared--banks were hoarding cash and not lending. The only way to correct this is to increase M, or the money supply. So, when people talk about the increase in the money supply, and express a concern, they ignored the decline in velocity that the increase in M was designed to offset.

As V gets back to normal, the Fed is an a position to reduce M.

Second, as you correctly stated, the decline in the dollar has not been dramatic. I would argue that the reason we are increasing the number of dollars is to play a game of chicken with trading partners, like the Chinese, who have artificially pegged their currency to ours and supported that policy by accumulating a large reserve of dollars. If we keep printing, they will have to back down and let their currency float or adjust it upward, or they will hold way too much currency.

 
At 10/16/2009 7:54 AM, Anonymous Anonymous said...

In my post of 7:50 am as anonymous, I neglected to say that I agree that the $ should be stabilizing, but I am not too concerned if it lowers. There has been deflation in the price of imports, and a declining dollar would not necessarily result in increased inflation at this time.

Oil may be a different matter, but I note that the Saudis now want to be compensated for less oil than is being purchased, which signals to me that there is a lot of excess capacity and growing non-Opec capacity.

Bill

 
At 10/16/2009 9:25 AM, Anonymous Anonymous said...

If we keep printing, they will have to back down and let their currency float or adjust it upward ...

How would this be good for us? The currency peg serves our interest in that it transfers their output to us at an artificially low cost. The Chinese people are the ones who bear the burden of this policy, we benifit. Don't forget, the Chinese have only one thing to sell the world - cheap labor. The currency peg is maintained to insure that that labor stays cheap.

 
At 10/16/2009 9:28 AM, Anonymous Anonymous said...

To anonymous at 9:25--Yes, if the Chinese artificially peg their currency it does injure them, but it also injures US manufacturers. We should favor floating and competitive currency markets.
Bill

 
At 10/16/2009 2:49 PM, Anonymous Anonymous said...

The U.S. is thus slated to enter the ranks of those countries—Zimbabwe, Japan, Lebanon, Singapore, Jamaica, Italy—with the highest government debt-to-GDP ratio (which measures the debt burden against a nation's capacity to generate sufficient wealth to repay its creditors). In 2008, the U.S. ranked 23rd on the list—crossing the 100% threshold vaults our nation into seventh place.

WSJ

 
At 10/16/2009 3:37 PM, Anonymous Anonymous said...

If GDP declines, debt to GDP increases. Long term debt to GDP has been fairly constant over business cycles.

Where we have a problem is PRIVATE debt to GDP which exploded from a high of 65% in 2005 to 105% in 2008. Government spending as a percent of GDP has remained around 20%.

We are on a path of delevaging private debt. To avoid a dropoff in aggregate demand from household delevaging, government stimulus, for a time, has a role to play until we are in recovery.

 

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