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

Your first international exhibit presents an overview of developments in selected international financial markets. As can be seen in the top left panel, a key development over the past half-year has been the renewed slide in the foreign exchange value of the dollar. The decline in the broad dollar (the black line) was due entirely to depreciation against the major currencies (the red line). The dollar fell to record lows against the euro (the black line on the right) but also fell substantially against the pound (the magenta line) and the yen (the blue line) as well as all the other major currencies. In contrast, since last summer the dollar has held its ground against the currencies of our other important trading partners, depicted by the blue line in the left panel. The dollar appreciated against the Mexican peso, while developing Asian governments generally continued to resist appreciation of the currencies, as indicated by the stability of the Korean won.

The other key development in international financial markets since your last chart show has been the response to expectations of rising economic growth. As indicated in your middle left panel, movements in long-term bond yields in major foreign economies have mirrored the rise in U.S. yields since last summer, as well as their recent slight decline. Stock prices, on the right, extended their second-quarter rebound through the end of the year, both in industrial countries and in emerging markets. As shown in the bottom left panel, another indicator of improving confidence, yield spreads for both emerging-market countries and industrial-country corporate borrowers, continued to move down last year. With EMBI+ spreads now at their lowest level since before the Russia crisis in 1998, some concerns have been raised that borrowing conditions have become too easy, raising the possibility of future financial crises. However, as shown on the right, gross capital flows to emerging-market countries remain well below their 1997 peaks, even as cross-border debt issuance by industrial economies has continued to grow.

Your next exhibit describes the recent and projected recovery of global economic growth. As indicated in the first row of the top left panel, our trade-weighted aggregate of foreign real GDP, after languishing in the first half of 2003, is estimated to have accelerated to a pace of nearly 4 percent in the second half. With monetary and fiscal conditions in most economies remaining accommodative, the global high- tech sector on the rebound, and U.S. growth projected to remain strong, we see foreign real GDP growth remaining brisk through 2004 before slowing a bit next year. This growth should gradually reduce the extent of economic slack abroad. It should also support continued expansion of international trade; as shown in the top right panel, the rebound in world exports over the past two years has mirrored the turnaround in global industrial production.

As indicated in the middle left panel, the acceleration in economic activity has also contributed, along with the decline in the dollar and other developments, to rebounds in oil prices (the black line) and other commodity prices (the red line). Going forward, oil prices are projected to decline over the next two years, in line with quotes from futures markets, as increasing supplies of Iraqi and non-OPEC oil become available, while nonfuel commodity prices level off. With commodity prices stabilizing and excess capacity projected to diminish only gradually, inflation rates, shown on the right, are expected to continue moving down in Latin America and to remain subdued in the industrial countries and developing Asia.

Returning to the top left panel of your exhibit, the second row indicates that the foreign industrial countries are expected to share in the global economic rebound, but at a slower pace than the world economy as a whole. Industrial country growth is expected to register just under 3 percent this year and next, and the path of euro-area growth (line 3) is expected to be lower still. As shown by the red line in the bottom left panel, industrial production in the euro area has moved up since the middle of last year, while the rise in business sentiment indicators such as the German Ifo survey (the black line) point to further strengthening. Going forward, the euro-area economy will likely benefit from the rebound in global growth and from continued low interest rates; however, it faces headwinds in the form of an appreciating currency and some move toward fiscal restraint.

In Japan (line 4 in the top left panel) GDP growth is expected to slow a bit in the next two years from the 2½ percent pace registered in the second half of 2003, notwithstanding the additional quantitative monetary easing announced by the Bank of Japan last week. As shown in the bottom right panel, available indicators suggest the economy is unlikely to fall back into recession. Machinery orders have moved up on balance in recent months while unemployment is edging down. Still, unemployment rates remain high by historical standards and are likely to restrain future consumption. Moreover, much of Japan’s growth in recent quarters has been due to buoyant exports to developing Asia; with growth in this region slated to slow from its brisk second-half rebound, and with the yen having strengthened recently, the stimulus from exports and export-related investment will likely diminish.

The outlook for the emerging-market economies is described in your next exhibit. As indicated in line 1 of the top left panel, real GDP growth for these countries rebounded at a 6.1 percent annual rate in the second half of last year and is projected to grow at still brisk rates over the next two years. The rebound in growth since last summer was due almost entirely to developing Asia (line 2), which grew at a blistering 11 percent pace in the second half after contracting slightly in the first half. This rebound in part reflected the recovery of retail sales, tourism, and confidence from the SARS epidemic. The rebound was also due to the continued recovery of the global high-tech sector; as shown in the top right panel, industrial production in many developing Asian countries has tracked the recovery in the global semiconductor industry. Finally, developing Asian growth has been boosted by buoyant domestic demand in China, including substantial state sector investment. As shown in the middle left panel, rising demand has helped to push consumer price inflation into positive territory—although much of the rise reflects higher food prices—and has also pushed down China’s trade surplus a bit. As shown on the right, exports of developing Asian economies to China (the red line) have soared, even as exports to the United States and Europe have been much weaker. While much of the increased exports to China are being drawn in by higher domestic demand, many of these goods are being further processed and re-exported to third markets. This reorientation of the region’s trade along more vertically integrated lines is evidenced in the bottom left panel, which shows that the recent growth of U.S. imports from Asia is accounted for exclusively by higher purchases from China.

In contrast to developing Asia, the recovery of growth in Latin America (line 5 in the top left panel) has been tentative. This is due in large part to lackluster performance in Mexico (line 6). As indicated in the bottom right panel, since mid- 2003, Mexican exports (the blue line) have recovered in tandem with U.S. industrial production (the black line). However, Mexican industrial production (the red line) has only recently turned up. The earlier weakness in Mexican production likely reflected runoffs of inventories, and with U.S. demand growth expected to remain strong over the forecast period, we are projecting a rebound in Mexican growth going forward. Nevertheless, several factors, including the failure of Mexico’s government to make progress on tax and energy-sector reforms, point to vulnerabilities in the economy’s performance.

Your next exhibit addresses the outlook for the U.S. external sector. As indicated in the top left panel, both U.S. export growth (the blue bars) and import growth (the red bars) were quite weak in the first half of 2003 but picked up substantially in the second half. This pattern reflects the recovery of GDP growth, shown at the right, with U.S. growth (the red bars) and foreign GDP (the blue bars) both rebounding from their subdued first-half performance. Going forward, continued rapid GDP growth here and abroad is expected to keep both exports and imports expanding briskly. I should note that, while beef exports fall nearly to zero for most of this year as a consequence of import bans prompted by mad cow disease, this should have only a very small effect on aggregate export sales.

Because U.S. growth is projected to exceed foreign growth and because the responsiveness of U.S. imports to income is believed to exceed that of U.S. exports to foreign income, the growth of imports would be expected to exceed that of exports, all else being equal. However, lagged effects of the past depreciation of the dollar, shown in the middle left panel, as well as effects of mild projected future depreciation are expected to buoy exports and restrain imports going forward. In consequence, the growth of exports is projected to exceed that of imports in 2004 and 2005. Nevertheless, because imports are substantially greater than exports, imports rise in absolute amount by more than exports over the forecast period. This leads to a further widening of the current account deficit, shown as the black line in the middle right panel. Owing to growth in the U.S. economy, the deficit as a percent of GDP, shown as the red line, narrows slightly over the next two years.

Returning to the middle left panel, our forecast of a modest further depreciation of the dollar is based on the view that the widening U.S. current account deficit and the need to finance it will continue to weigh on the dollar. Nevertheless, the timing and magnitude of any future additional decline is obviously quite uncertain. The bottom panel of your exhibit breaks down the recent financing of the current account, shown on line 1. Notably, the share of the financing coming from official sources (line 2) has stepped up considerably over the past year, reaching about $250 billion at an annual rate in the first two months of the fourth quarter. Conversely, net private capital flows (line 3) have moved down. Foreign purchases of U.S. securities (line 4) declined from $418 billion at an annual rate in the first half of 2003 to a little over $300 billion in the first two months of the fourth quarter. Interpreting these data is complicated, however, as purchases in September and October were extremely weak, whereas they bounced back in November. Data on foreign direct investment in the United States (line 6) are available only through the third quarter of last year, but these inflows also show a decline from 2003:H1. Conversely, U.S. purchases of foreign securities (line 5) and U.S. direct investment abroad (line 7) appear to have held up well in the second half of last year. These data suggest that official purchases of dollars increasingly are substituting for private capital inflows in financing the U.S. current account deficit and, as such, may be preventing the dollar from moving down more rapidly than would otherwise be the case.

Your final exhibit explores some alternative scenarios for the dollar. As indicated by the black line in the top panel, the broad real dollar, though down considerably from its peak in early 2002, is still well above its trough in the 1990s. Particularly given the widening external deficit, a steeper decline in the dollar than our baseline projection is a distinct possibility. However, the implications for the U.S. and foreign economies will depend upon the circumstances in which this decline takes place. The middle left panel details several alternative simulations of the staff’s model. In the first scenario, indicated by the solid red line, the fall in the dollar is triggered by higher-than-expected foreign GDP growth. Such higher growth might plausibly be due to the long-awaited rise in productivity growth among foreign industrial countries, for example, or to a pickup of investment and consumption in developing Asia. Specifically, this scenario combines a shock to the risk premium on U.S. assets, which would lead to a 10 percent decline in the dollar in the absence of changes in monetary policy, with a shock to foreign domestic demand equal to 1 percent of GDP in 2004 and an additional 2 percent of GDP in 2005. This combination of higher foreign growth, indicated by the red line in the bottom left panel, and the lower dollar leads to an improvement in the U.S. current account balance, the bottom right panel, and a rise in U.S. growth of about ½ percentage point, the middle right.

The second dollar depreciation scenario is a so-called disorderly correction—that is, a rapid fall in the dollar that engenders a steep falloff in U.S. bond and equity prices as well. It is not clear how plausible this scenario is. The fall in the dollar since early 2002 has not disrupted financial markets, nor did it do so during the dollar’s previous correction in the 1980s. Nevertheless, this scenario arises frequently in financial press commentary on the dollar. So to explore its effects, we assumed the same shock to the dollar as in scenario 1 but added shocks to risk premiums in other asset markets that lower U.S. stock prices about 12 percent and raise long-term bond yields 50 basis points. The combined effect of these shocks is to leave U.S. growth (the dashed red line in the middle right panel) down only a little from its baseline path, as the adverse effects of higher interest rates and lower stock prices are offset by the stimulative effect of the dollar’s decline on net exports. However, foreign growth is lowered about ½ percentage point below baseline, reflecting both the appreciation of their currencies and lower U.S. growth.

Finally, while we view the risks to the dollar to be weighted toward the downside, we cannot preclude the possibility that the dollar may rise above its projected path over the next several quarters. Our projection of U.S. real GDP growth exceeds that of most private forecasters, and as the market’s assessment of U.S. growth and associated rates of return is adjusted upward, the dollar may be boosted as well. The blue dashed lines in your exhibit trace out the effects of such a shock. While foreign growth is boosted above its baseline path, U.S. growth is restrained a bit, and the current account deficit widens. To sum up, considerable uncertainty surrounds both future movements of the dollar and the circumstances under which such movements might occur. At the risk of saying something you may have heard here before, this makes the outlook for the U.S. external sector particularly difficult to pin down at the present time. [Laughter] Sandy will now continue our presentation.

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