Transcripts of the monetary policymaking body of the Federal Reserve from 2002–2008.

The baseline forecast for real output growth in the rest of the world is little changed from that in the August Greenbook. This is the case despite substantial market volatility of, and much media attention to, global oil prices. The primary reason is that despite the intermeeting fluctuations, the path of oil prices implicit in futures prices showed little net change from the path incorporated in the August Greenbook. We did look very carefully at the question of how the effects of elevated oil prices are likely to be distributed across foreign economies. And there are differences among industrial countries, emerging-market economies, net oil importers, and net oil exporters. Nevertheless, the basic common elements of reduced oil intensity in several foreign countries, especially the foreign industrial countries, and well-anchored inflation expectations in most important foreign economies, along with the expectation that only a portion of the spike in spot prices will prove to be persistent, have led us and most forecasters to judge that the output effects of recent oil market developments will be limited.

Our initial projection for growth abroad in 2006 is that foreign real GDP will expand at about 3¼ percent, a slight deceleration from the 3½ percent annual pace of the second half of this year. Among the industrial countries, most of the stepdown in growth is accounted for by Canada and the United Kingdom, countries whose economies have been expanding particularly rapidly, closing their output gaps, and that need to bring growth in line with potential in order to avert the emergence of inflationary pressures. The central banks of both those countries have already moved to tighten policy, with the Bank of Canada tightening 25 basis points earlier this month and the Bank of England increasing rates by a total of 125 basis points since mid-2003. Some deceleration is also projected for the Asian developing economies on average, particularly in Malaysia, Singapore, Taiwan, and Indonesia. Elevated oil prices are boosting headline inflation abroad, but core price inflation, where data are available, appears to be well contained. Over the forecast period, we expect inflation abroad to decline gradually as oil prices reverse some of their recent run-up and as food prices, which have been a factor in Asia, retreat in response to increased supply, and as monetary tightening in Brazil and Mexico have some effect.

Extension of the forecast horizon to the end of 2006 allows the effects of returns to near-trend growth here and in most regions abroad to show through to our projections for real net exports, the nominal trade deficit, and the current account deficit. The consequences of weakness in activity here and abroad earlier, past dollar depreciation, and sharp swings in oil and nonfuel commodity prices will have been pretty much fully felt by the end of 2005. For this forecast, we have projected slightly more rapid depreciation of the dollar than previously, with the broad dollar decline averaging nearly 1½ percent in real terms in 2005 and 2006. We judge that such an outcome in relative income here and abroad and in price competitiveness of U.S. goods would lead to a widening of the nominal U.S. trade deficit of about $90 billion from its current average through the last quarter of 2006. In addition, prospective increases in market dollar interest rates, along with other factors, imply that U.S. net investment income will move into deficit, declining nearly as much as the trade deficit over the same period. As a result, our projection for the current account balance widens from about $700 billion this quarter to nearly $880 billion in the fourth quarter of 2006, reaching about 6½ percent of GDP. In real terms, there is an equivalent deterioration. The positive contribution from real exports to overall GDP growth slowly diminishes from more than 0.8 percentage point this year to less than 0.7 percentage point in 2006. And the negative contribution from imports remains above 1 percentage point, reaching 1.3 percentage points over the four quarters of 2006. There is thus a persistent subtraction from U.S. GDP growth that arises from the external sector and that reaches about ⅔ percentage point in 2006. The slight deceleration in real export growth primarily reflects a lessening of the past impetus coming from relative prices, particularly from the exchange rate. Similarly, the strengthening in real import growth arises largely from a relative price boost. Of course, real export growth would have to exceed that of real imports substantially at this point for real net exports to have a neutral effect on the forecast for U.S. GDP growth.

Only a few forecasters have added 2006 to their outlooks. Although we are not absolutely alone in anticipating a marked deterioration in the external balance over the next two years, many forecasters currently call for little change from this year to next. For example, the average current account deficit polled by Consensus Forecasts is about $625 billion for both 2004 and 2005. Of course, some of the individual outlooks in that average call for the deficit to widen, but some actually project a narrowing. Plus, a number above $800 billion for 2006 seems to be way off the radar screen of most forecasters.

Our view that the current account deficit will widen into rather startling new territory reflects the large size that the deficit has already reached and our projected path for the dollar. Trend growth here and abroad is consistent with the deficit widening further unless relative prices change, and the present large deficit means that the decline in the nominal balance moves quickly as likely growth rates yield rapidly diverging exports and imports. This poses a severe challenge to us with respect to our projection for the exchange value of the dollar in the baseline forecast.

For some time we have taken to heart the results of research that we and others have done that shows that structural models of the exchange rate have little forecasting power. Accordingly, we have incorporated into the forecast paths for the real value of the dollar that are nearly flat, with some slight trend at times to signal features of the maintained assumption about U.S. monetary policy or our ongoing concern that the financing of the U.S. external deficit would ultimately result in downward pressure on the dollar. But that strategy now results in the external sector having a very prominent effect on the top-line GDP path. Moreover, as the numbers we are writing down get larger and larger, we are beginning to have doubts that financial markets will be able to manage them easily. However, no clearly better alternative comes to mind. If we arbitrarily projected a path for the dollar that minimizes the negative effects coming from the external sector, then we would be masking an important feature of the U.S. macroeconomy, and that dollar path, rather than net exports, would become the essence of the international forecast. Because we do not believe that we truly can project when any major change in the value of the dollar will happen, in particular whether it will happen within the forecast interval, we do not see any basis on which we could follow that strategy. For now, we have used the alternative simulation in the Greenbook to suggest to you what would be the consequences of a sharp move in the dollar sometime in the forecast period. As awareness of the looming external deficits becomes more widespread, we may see more clues in financial markets as to what to expect from them. Dave and I would be happy to answer any of your questions.

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