Based On M2 Growth, The US 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.

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