A few months ago, when Karen Johnson asked me to fill in for her at the December FOMC meeting, I immediately wrote to Santa Claus and asked, as my present, for some major international event to take place, be it an emerging- market crisis, skyrocketing commodity prices, or a spectacular collapse of the dollar. Such developments are not always welcomed by financial market participants or by ordinary working people, but they certainly make for interesting conversation. [Laughter] Well, if you believe what you read in the financial press, Santa granted me my third wish: As Dino has discussed, since you last met, the dollar is down about 5 percent against the euro and 4½ percent against sterling. Two weeks ago, The Economist saw fit to put on its cover a picture of a dollar bill with George Washington’s jaw dropping.
To put these recent developments in perspective, however, the dollar declined considerably less against the currencies of most of our other major trading partners, and the broad dollar has fallen only about 2 percent over the intermeeting period. This is still a significant decline for so short a period, but is only half the size of the drop posted between the March and May FOMC meetings earlier this year. Also, we have seen nothing to indicate that a major rebalancing of investor portfolios away from the greenback is imminent. Accordingly, as is our practice, in our forecast we have adjusted down the starting point for the projected path of the dollar but continue to project only a modest decline in its real value going forward.
Even before the dollar’s recent decline, we were seeing some limited evidence of improvement in the U.S. external balance. A few weeks after your October meeting, we received data indicating that the monthly nominal trade deficit had shrunk from a record $69 billion in August to $64 billion in September. Although this downshift principally reflected declines in the price of imported oil, the trade deficit had been boosted by rising oil prices earlier this year, and their subsequent fall and stabilization at least should diminish one factor widening the deficit going forward. This morning, October trade data were released; they indicate that the trade deficit shrank a bit further, to about $59 billion. This deficit was even smaller than we’d anticipated, with exports a bit stronger and imports a bit weaker.
The recent performance of real net exports also appears a little more positive. The September trade data and other recent information point to somewhat weaker- than-expected real import growth in the third quarter and nearly flat real imports in the current quarter; this flattening is due in part to a sharp decline in the volume of oil imports as domestic users work off an unusually high level of inventories. With real exports estimated to have continued expanding solidly, the December Greenbook shows real net exports in the third and fourth quarters combined adding slightly to U.S. GDP growth in comparison with the slight drag we wrote down in October. This morning’s October trade release suggests that we’ll probably revise that contribution up a little further.
Over the next two years, real import growth should pick up as U.S. activity accelerates and oil imports stabilize. With export growth holding steady, supported by the ongoing expansion abroad and the declining dollar, real net exports start deteriorating again and subtract about 0.1 percentage point from GDP growth in 2007 and 0.25 percentage point in 2008. This drag is quite small, however, compared with the nearly 0.5 percentage point drag exerted by net exports on average from 2000 through 2006. It is also about 0.1 percentage point smaller than in the October Greenbook, and we would attribute this principally to the weaker dollar.
Consistent with the improved performance of net exports, the weaker dollar has also led us to project slightly stronger trade and current account balances. The current account deficit now expands just a touch, from about 6¾ percent of GDP at present to 7 percent by the end of 2008, whereas the trade deficit remains about flat as a share of GDP—at around 5½ percent—over the forecast period. Does this flattening out suggest that sustainability of the U.S. external balance is just around the corner? Absolutely not! [Laughter] The trade deficit is still projected to widen a bit in nominal, dollar-value terms. As long as the trade balance remains substantially in deficit, borrowing to finance that deficit ultimately will lead to growing external debt, rising payments on that debt, and ever-larger current account deficits. Our projection has the net international investment position, which was negative 21 percent of GDP in 2005, sliding to negative 36 percent of GDP by 2008.
The slower deterioration of U.S. external balances that we anticipate depends on continued solid economic growth among our trading partners. Our trade-weighted aggregate of foreign real GDP growth clocked in at about 4½ percent in the first half of this year, which likely was a little faster than its trend rate. The data we’ve received since the October Greenbook reinforce our view that a stepdown is in train, with growth in China, Mexico, Japan, and the euro area all slowing in the third quarter from previous unusually elevated rates. We estimate that, all told, the foreign economy decelerated to a pace of 3¼ percent in the second half of this year, and we see it staying at this more sustainable rate going forward.
Can foreign growth remain this strong, even as U.S. GDP growth is projected to average less than 2½ percent over the forecast period? U.S. growth and foreign growth are highly correlated, reflecting both direct trade links and indirect links through financial markets and confidence effects. However, growth rates here and abroad do not move in lockstep. Over the past thirty years, gaps in excess of 2 to 3 percentage points have periodically opened up between U.S. and foreign growth; at about 1 percentage point, the growth differential we are projecting is not unusual. Of course, were the United States to fall into recession, this would likely be bad news for our trading partners. Since 1970, five recessions have been dated for the U.S. economy, and on all those occasions foreign growth slumped as well.
As we put together our outlook, we also had to consider whether it would take a sharper slowdown than we are projecting to prevent widespread inflationary pressures. We are heartened to see that, as in the United States, the decline in oil prices since August has led to sharp declines in headline CPI inflation in many of our trading partners. For example, euro-area twelve-month inflation has fallen through the ECB’s 2 percent target ceiling to only 1.8 percent, while Canadian inflation has fallen to 1 percent.
However, inflation abroad should pick up again with projected increases in oil prices. Moreover, resource utilization abroad has been rising, and it is difficult to identify much slack in the major foreign economies. To date, measures of core inflation and wage growth are not signaling significant upward pressures, but unemployment rates are generally near lows last reached at the end of the 1990s. The emergence of more-pronounced inflationary pressures, should that occur, would likely trigger a more substantial further tightening of monetary policy and financial conditions than we are currently anticipating, leading to a falloff from the steady foreign growth called for in the Greenbook forecast. This, in turn, could put the U.S. trade and current account balances on a more negative trajectory than we now expect. That concludes my remarks.