Money Supply & the Dollar

How differing rates of "money growth" are weakening the US Dollar...

AT THE END of September the price of the Euro in US Dollar terms closed at 1.357 – an increase of 7% from the end of August, writes Dr.Frank Shostak, chief economist at MF Global in Australia and a regular contributor to the Austrian-school Mises.org, for the Cobden Centre.

The yearly rate of growth of the price of Euro stood at minus 7.3% in September against minus 11.5% in the month before.

The currency rate of exchange seems to be moving in response to so
many factors that it makes it almost impossible to ascertain where the
rate of exchange is likely to be headed.  We suggest that rather than
paying attention to the multitude of apparent variables, it is more
sensible to focus on the essential variable. As far as currency rate of
exchange determination is concerned we suggest that this variable is the
relative changes in the purchasing power of various monies. In short,
it is the relative purchasing power of various monies that set the
underlying rate of exchange.

A price of a basket of goods is the amount of money paid for the
basket. We can also say that the amount of money paid for a basket of
goods is the purchasing power of money with respect to the basket of
goods. If in the US the price of a basket of goods is $1 and in Europe an identical basket of goods is sold for 2 euros then the rate of exchange between the US$ and the euro must be two euros per one dollar.

An important factor in setting the purchasing power of money is the
supply of money. If over time the rate of growth in the US money supply
exceeds the rate of growth of European money supply, all other things
being equal, this will put pressure on the US$. Since a price of a good
is the amount of money asked for the good, this now means that the
prices of goods in dollar terms will increase faster than prices in euro
terms, all other things being equal.

As a result an identical basket of goods is priced now, let us say at $2, as against 2.5 euro. This would imply that the exchange rate between the US$ and the euro will be now 1.25
euros per one dollar. Note the fact that changes in a money supply
affect its general purchasing power with a time lag means that changes
in relative money supply affect the currency rate of exchange also with a
time lag. (When money is injected into the economy it starts with a
particular market before it goes to other markets – this is the reason
for the lag. When it enters a particular market it pushes the price of a
good in this market higher – more money is spent on given goods than
before). This in turn means that past and present information about
money supply can be employed in ascertaining likely future moves in the
currency rate of exchange.

Another important factor in driving the purchasing power of money and
the currency rate of exchange is the demand for money. For instance,
with an increase in the production of goods the demand for money will
follow suit. The demand for the services of the medium of exchange will
increase since more goods must now be exchanged. As a result, for a
given supply of money, the purchasing power of money will increase. 
Less money will be chasing more goods now. Various factors, such as the
interest rate differential, can cause a deviation of the currency rate
of exchange from the level dictated by relative purchasing power. Such
deviation, however, will set corrective forces in motion.

Let us say that the Fed raises its policy interest rate while the
European central bank keeps its policy rate unchanged. We have seen that
if the price of a basket of goods in the US is one dollar and in Europe
two euros, then according to the purchasing power framework the
currency rate of exchange should be one dollar for two euros. As a
result of a widening in the interest rate differential between the US
and the Euro-zone an increase in the demand for dollars pushes the
exchange rate in the market toward one dollar for three euros. This
means that the dollar is now overvalued as depicted by the relative
purchasing power of the dollar versus the euro.

In this situation it will pay to sell the basket of goods for dollars
then exchange dollars for euros and then buy the basket of goods with
euros – thus making a clear arbitrage gain. For example individuals will
sell a basket of goods for one dollar, exchange the one dollar for
three euros, and then exchange three euros for 1.5 basket, gaining 0.5
a basket of goods. The fact that the holder of dollars will increase
his/her demand for euros in order to profit from the arbitrage will make
euros more expensive in terms of dollars – pushing the exchange rate in
the direction of one dollar for two euros.  (We suggest that the
arbitrage will always be set in motion if the rate of exchange deviates,
for whatever reasons, from the underlying rate of exchange).

Since November 2009 the money growth differential between the US and
the Euro-zone has been in a visible increase. After closing at minus 24% in November 2009 the differential jumped to minus 4.2%
in August this year. We suggest that the strengthening in the
differential is the key reason for the underlying strengthening in the
Euro against the US$. Given the relatively more conservative Euro-zone
central bank versus the US central bank it is quite likely that the
money growth differential will continue to strengthen further – thus
providing further support to the Euro.

After closing at minus 3.7% in April the growth differential between
US and Euro-zone industrial production climbed to 0.11% in August. We
envisage that in the months ahead the differential is likely to
stabilize at the August figure. So from this perspective the slight
increase in the differential is likely to provide only marginal support
to the US$ versus the Euro. The differential between the federal funds
rate and the European central bank policy interest rate is likely to
stand at minus 0.75% in the months ahead. (The fed funds rate is
forecast at 0.25% while the ECB rate at 1%). So from this perspective it
is going to have neutral effect on the price of Euro in US dollar
terms.

Again we maintain that the strong support for the Euro versus the US$
is on account of a strengthening in the money growth differential since
November 2009. (Note again that the effect from changes in money supply
and the differential works on the currency rate of exchange
determination with a time lag). This means that the US$ is likely to
remain under pressure. An increase in the industrial production
differential is likely to mitigate the strengthening of the Euro against
the US$. On a short-term basis the price of the euro in US dollar terms
appears to be just about “right” as far as the valuation versus its
12-month moving average is concerned. The price to its 12-month moving
average ratio stood at 1.0 in September versus 0.9 in August. Note that in September last year the ratio stood at 1.08.

Prospects for the Yen against the US dollar

At the end of September the price of the US$ in Yen terms closed at 83.9 – a fall of 0.3% from the end of August. Year-on-year the price of the US$ in Yen terms fell by 6.5% in September after declining by 9.5%
in the month before. Observe that the Yen has been strengthening
against the US$ since July 2007. The price of the dollar to its 12-month
moving average stood at 0.94 in September the same figure as in August. Note that in September last year the ratio stood at 0.946.

Since November 2009 the money growth spread between the US and Japan has been trending up. The differential stood at 2.8% in August against 2.1% in July and minus 13% in November last year. Now after falling to minus 29.1% in February the industrial production growth spread between the US and Japan climbed to minus 9.2%
in August. In the months ahead we expect the growth spread to stabilize
at around the August figure. The interest rate spread doesn’t have much
importance at present given the policy rates in US and Japan are close
to nil. We suggest that in the months ahead the money growth
differential is likely to dominate the currency rate of exchange scene.
This implies that the price of the US$ in yen terms is likely to remain
under pressure.

Money growth differential continues to support Aussie dollar against the US dollar

At the end of September the price of the A$ in terms of US$ closed at 0.967 – an increase of 8.5%
from the end of August. The growth momentum of the price of the A$ has
also strengthened visibly. The yearly rate of growth jumped to 9.4% from 5.4% in August. The ratio of the A$/US$ to its 12-month moving average climbed to 1.076 in September from 0.999
in the month before – this could be interpreted that relatively to its
12- month moving average the price of the A$ in US$ terms is
over-stretched.

A major factor behind the strengthening in the A$ against the US$ is a
visible strengthening in the money growth differential between the US
and Australia. After falling to minus 15% in November last year the differential shot up to 9.1% in June before settling at 7.6%
in August. From the demand for Aussie dollars perspective a strong
increase in the price of gold provides important support for the
Australian currency versus the US dollar. From these two key factors we
suggest that for the time being the Aussie dollar is going to be well
supported in the months ahead, all other things being equal.

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