Your first international exhibit focuses on the dollar. As indicated by the red line in the top-left panel, despite widening U.S. external imbalances, the dollar rose strongly against the major currencies through much of 2005. As seen on the top right, against the euro and the yen, the dollar has recorded net gains of more than 10 percent over the past year, even after tailing off some during the last two months. The dollar’s rise against these currencies occurred as interest rate differentials (shown on the bottom left) moved strongly in favor of dollar assets, and market commentary has pointed to this as a key factor supporting the dollar. Against the Canadian dollar, however, the greenback has moved down since mid-2005, and—as displayed on the bottom right—the dollar has also fallen against an array of emerging-market currencies, as market confidence in these countries has climbed. On balance, the broad nominal dollar has strengthened about 1¾ percent over the past year.
As shown in the top panels of exhibit 10, the dollar’s resilience last year came in the context of a shift in the composition of reported U.S. financial inflows, away from official financing and toward private financing. In 2005, foreign official inflows (line 1 on the left) were down sharply from their 2004 pace. A plunge in official inflows from the G-10 countries (line 2) led this decline, as the Japanese authorities ceased intervening in foreign exchange markets. In contrast, inflows from emerging Asia (line 3) continued to move up, reflecting massive reserve accumulation by China.
Purchases of U.S. securities by private foreigners (the top right panel) surged last year to more than $700 billion. All major categories of instruments saw increased foreign purchases, with particularly large gains in Treasury securities (line 2) and corporate bonds (line 4).
The positive sentiment toward the emerging market economies, which was seen in foreign exchange markets, has also been manifest in global debt markets. As shown on the bottom left, the EMBI+ spread—which had hovered above the U.S. double-B corporate spread in recent years—cut below the double-B spread in mid-2005 and has now sunk to historical lows of just above 200 basis points. These favorable conditions, however, have not triggered a rise in external borrowing. As shown on the bottom right, net issuance of international debt securities by the emerging Asian economies has remained stable over the last year or two, and the Latin American countries have been paying down debt on net. Moreover, a sizable fraction of these economies continue to run current account surpluses.
Your next exhibit focuses on the outlook for activity abroad, which in our view is quite favorable. As shown in line 1 of the top left panel, we estimate that total foreign growth in the second half of last year climbed to 4.1 percent, as growth in the emerging market economies (line 6) exceeded 6 percent. Going forward, we expect the foreign economies on average to expand at a strong pace of 3½ percent. Recent data have pointed to renewed signs of life in the euro-area economy (line 3), particularly in Germany, as strengthening in the export sector appears to have jump- started investment. We expect this impetus eventually to feed through to increased employment and consumer spending. Accordingly, we have marked up our forecast for the euro area and now expect growth there to remain near the 2 percent pace posted in the second half of 2005. Our forecast for Japan (line 4) calls for the expansion to broaden and for growth to remain above our estimate of potential. As shown in the middle left panel, over the past decade, Japanese corporations have dramatically reduced their debt burdens (the blue line). As balance sheets have strengthened, business investment (the black line) has risen and labor market conditions (the red line) have improved. More recently, as shown on the right, urban land prices—after many years of sharp contraction—appear to have stopped falling, and bank credit seems to be following a similar pattern. These developments suggest that conditions in the Japanese financial sector may finally be normalizing.
The bottom panels focus on China. Over the intermeeting period, the Chinese authorities reported that GDP in 2004 was $280 billion (or 17 percent) larger than they had previously realized. Given these revisions, China’s GDP last year now appears to have exceeded that of France and the United Kingdom, making China the world’s fourth-largest economy. Other recent data indicate that China’s trade surplus (displayed on the right) jumped to $100 billion in 2005, as import growth declined sharply. Returning to the top left panel, this deceleration in imports did not reflect a slowing in the overall pace of Chinese activity last year, as GDP growth (line 8) remained near 10 percent. We see growth there notching down to around 7¾ percent in 2006, as the authorities are expected to implement administrative measures to restrain investment.
As displayed in the top right panel, average foreign inflation is projected to remain well contained, cycling near 2½ percent through the forecast period. Inflation rates in the foreign industrial countries are seen to step down in mid-2006, as the run- up in oil prices plays through.
For the emerging market economies, oil price increases typically pass through into consumer prices more slowly, as a number of these countries have price controls or subsidies in place that temporarily cushion the upward pressure on prices. As such, the rise in oil prices should continue to push up consumer price inflation through the next few quarters, but these pressures should abate in 2007.
The top panels of exhibit 12 focus on trade prices. As shown on the left, the spot price of West Texas intermediate (the black line) has surged about $20 per barrel over the past year and now trades above $65 per barrel. Oil prices have been driven up both by strong global demand and by concerns about the reliability and adequacy of global supplies. Recent developments in Iran, Iraq, and Nigeria have further intensified these concerns. Tracking futures markets, our forecast calls for the price of WTI to remain elevated through the end of 2007. Nonfuel commodity prices (the red line) have also risen sharply over the past year, as metals prices have surged in response to strong global demand. In sync with futures markets, our forecast calls for commodity prices to flatten out near current levels, as supply responses help cap further price rises.
The center panel displays our projection for the broad real dollar. After rising somewhat on balance last year, the dollar is projected to depreciate slightly, at an annual rate of about 1⅓ percent, through the forecast period. We see the expanding current account deficit and associated financing concerns—as well as monetary tightening by some foreign central banks—as likely to be sources of downward pressure on the dollar.
Core import prices (the right panel) spiked in the fourth quarter, driven largely by a surge in natural gas prices following the hurricanes. Given that natural gas prices have already retreated, the run-up in core import price inflation should quickly unwind. Smoothing through these fluctuations, we see core import price inflation moving down to around 1 percent by early next year, consistent with flat commodity prices and only modest dollar depreciation.
Recent data on U.S. nominal trade (the bottom left panel) indicate that the trade deficit has widened further. In October and November, exports of goods and services (line 2) increased $17 billion, led by a rise in capital goods exports (line 3), owing in part to a rebound in aircraft exports following the Boeing strike in September. Notably, exports of industrial supplies in October and November (line 4) were down relative to the third quarter. A large share of U.S. firms that produce these goods are located in hurricane-affected areas, and their production has been temporarily impaired. As shown on the right, this circumstance is highlighted by a sharp drop in real exports from several industries that were particularly affected by the hurricanes.
Nominal imports of goods and services (line 6 on the table) rose a hefty $80 billion in October and November, notwithstanding soft growth in consumer goods (line 7) and capital goods (line 8). The recent rise in imports primarily reflected large increases in industrial supplies (line 9) and oil (line 10). These gains were due both to higher import prices, particularly for oil and natural gas, and to rising import quantities (which have substituted for impaired domestic production). Notably, as seen on the right, real imports have risen sharply in some of the same hurricane-affected industries in which exports have been particularly weak.
As shown in the top left panel of your final international exhibit, we estimate that the growth of U.S. real exports of goods and services (the blue bars) dipped during the second half of 2005, as the hurricanes contributed to softness in goods exports and as last year’s dollar appreciation reduced the stimulus to services exports. Imports (the red bars), in contrast, expanded at a solid rate in the second half of last year, with a boost from the hurricanes. This pattern is expected to reverse in the first half of 2006, with exports recovering from the effects of the hurricanes and imports of oil and industrial supplies moderating. Thereafter, imports and exports are projected to grow at comparable paces, in line with solid U.S. and foreign growth and with the dollar projected to depreciate only mildly. As shown by the black line in the top right panel, the contribution of net exports to U.S. GDP growth in the second half of last year is estimated to have been around negative 0.6 percentage point, but it is projected to swing slightly positive in the first half of this year. Subsequently, the subtraction due to net exports should run at roughly ⅓ percentage point; imports and exports grow at comparable rates, but with imports more than 50 percent larger than exports, a sizable subtraction from growth results.
As shown in the middle left panel, the U.S. current account deficit widened from about $150 billion in 1997 to $780 billion in the third quarter of last year. Over the forecast period, we see the deficit increasing further, to over $1 trillion, or about 7½ percent of GDP. The bottom panel provides some additional perspective on the widening of the current account deficit. As shown in the first column, from 1997:Q1 to 2001:Q4—a period of dollar appreciation—the current account balance fell $217 billion, which was more than accounted for by a decline in the non-oil trade balance. Over the next four years (the second column), the current account balance dropped another $421 billion, largely because of a continued decline in the non-oil trade balance (despite a net depreciation of the dollar) and a sharp rise in oil imports. As shown in the last column, we expect the current account deficit to widen nearly $300 billion over the forecast period, with all four major components contributing to the decline. Notably, net investment income is expected to fall sharply, as growing U.S. indebtedness and rising short-term interest rates push up our payments to foreigners.
The middle right panel shows that our current account projections for 2006 and 2007 are markedly gloomier than those of other forecasters. Thus, there is a distinct possibility that investors will be surprised by the extent that the current account deficit widens. We see this as representing an important downside risk for the dollar.