So Ben Bernanke has been called in by worried congressmen to explain US monetary policy. The wording of the statement accompanying the March Open Markets Committee meeting has been pored over in minute detail and time and again by financial market Kremlinologists seeking to get to the bottom of what Mr Bernanke's coterie really mean. We agree with the Financial Times leader article (27th March) which draws attention to the scope for confusion implicit within the absence of an official inflation target and where, as a nominal demand manager, senior Fed officials have constantly to walk the tightrope between concern over inflation and concern over growth and its impact on employment. But whilst we accept the statement's opacity we have a strong view as to which side Fed officials should be leaning.
The outlook for the dollar
The starting point is, as ever, with the outlook for the dollar. We wrote, in last week's Week In Preview note, that we anticipated a resumption in the dollar's secular decline after a two year hiatus. This writer enjoyed reading Mr Larry Summers' article in the comment section of the Financial Times (Monday 26th March) in which it was argued that Fed policymakers must look to the future rather than attempt to correct the mistakes of the past and that those in the rest of the world who argue in favour of a rise in the US savings ratio and correction of the US current account deficit should be careful what they wish for. Well this is how we see an adjustment playing out.
We revisit a theme running throughout Week In Previews of the past two years when we consider the environment in which the US current account deficit falls from a level in excess of 6% of GDP to closer to what might be regarded as a sustainable level (say 2%) given prevailing capital inflows and the increasing desire on the part of Asian central bankers to speed up the process of reserve diversification. The dollar would weaken, but that is not all. Balance of payments crises happen when credit gets withdrawn. Not surprisingly, the knock-on impact on economic growth tends to be significant (just as it is for companies and for consumers when they spend beyond their means and credit is withdrawn).
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In such circumstances consumption adjusts very quickly to the new environment and this tends to happen almost entirely through a reduction in imports (exports rise only gradually at first, in response to currency weakness). Put simply, US exports would expand only very slowly, while imports would contract. But because exports and imports make up a very small share of the US economy (10% and 16% respectively), achieving a 4% adjustment on the current account would prove very painful. Pressure on the dollar would intensify and long-term interest rates would rise as demand for dollars faded. Inflation pressure might be expected to rise but, we suspect, only very modestly.
US current account adjustment
None of the world's major developed economies (UK, Euroland and Japan) have current account deficits anywhere near as large as that of the US. There are, however, plenty of examples of emerging economies which have been through similar sized adjustments and a number of examples of developed economies which have been through smaller adjustments. In every case (regardless of how big a country is), when credit gets cut off the economy needs to adjust and that adjustment tends to happen very quickly (c two years if emerging markets are anything to go by, during which time the average starting deficit tends to be around 1.5% wider than that of the US at present). During the adjustment process, GDP growth tends to slow sharply (again, by about 4-5% if emerging economies are anything to go by).
The slowdown is caused, in every case, by money pulling back. In the late 1980's the US had a relatively minor adjustment as the current account deficit narrowed from 3.5% to 2.0% of GDP in response to a weakening currency. Only later, when the US economy dived into recession did the deficit disappear altogether. Critically, the relationship between relative growth and the current account is strong. For the current account to adjust as much as it is going to have to the US economy is going to have to weaken a lot (if the recession of the early 1990's is anything to go by, annualised growth may have to slow to as little as 1%). This is not our central projection but it remains a key threat to that projection.
As the adjustment gets underway the current account deficit begins by widening as a country's (any country) deficit responds adversely to the still strong currency and lack of competitiveness. As the adjustment process takes over growth responds to a sharp pull-back in imports. The rebound in exports is much slower (approximately two years on average for exporters to identify a trend, respond to it and allocate resources so best to benefit from it). On average the drop in imports is historically about 20%. In the US case this might take imports percentage of GDP down from 16% to c12.8%. this decline would be almost twice as big as the adjustment that took place during the previous recession (little wonder that European and Japanese politicians are worried!). The reason why we think that this might happen is that the basic pattern of the deterioration in the US current account deficit is typical. Exports are uncompetitive and imports have soared. So the unwinding will be typical too, with imports falling faster than exports grow.
Why Europe has benefited from export uncompetitiveness
The unusual part of the whole scenario is that the dollar has been in secular decline and yet the deficit is getting worse, not better. In substantial part this is due to the shift in the US major trading partners over the past decade and in particular the emergence of China thanks, in no small part, to the existence of the pegged currency. The big beneficiary of US export uncompetitiveness has not been Europe, it has been China!
Because China is so competitive capital is pouring into the country. But because the Chinese authorities are not allowing this capital inflow to drive the exchange rate higher, which naturally it would do, the funds are simply being recycled back out of the country and into foreign exchange reserves. The pace at which this process has been taking place has barely paused for breath, a strong indication that underlying problems in that country have not gone away. It is indeed ironic that the dollar's effective devaluation since 2001 has actually contributed to Chinese competitiveness (i.e. by pegging its currency to the dollar China has devalued along with the US). Observers have been quick to note how this has prevented the necessary adjustment in the US current account deficit and contributed to the loss of more than 2m US jobs.
The world's supply of labour has effectively quadrupled with the emergence of China and India as economic superpowers. Economic textbooks typically refer to a three-way division in an economy, in which the shares of the pie are broken down between labour, capital and natural resources. The size of the share of each varies as a function of their relative supply and demand. Over the past few years we have witnessed a rapid decline in the value of labour (helping to keep insidious wage inflation under control) and a rapid increase in the value of natural resources. This is most obviously indicated by reference to what China is importing (commodities) and exporting (manufactured goods). It is also reflected in the amount of outsourcing that is taking place to China and India and as a consequence the US is losing market share to those countries. The result of these trends, if the dollar is not devalued, is likely to see the US current account deficit rise from current levels to c8%-10% of GDP within five to ten years.
Expect a typical adjustment
Whilst it is always dangerous to look to the past to extrapolate what might happen in the future, the extent to which the US current account deficit has expanded is following typical lines. We therefore expect the adjustment to be typical too. The dollar's decline will need to be significant in order to restore US competitiveness to earlier levels. Rising exports may well cushion part of the blow, but exports are notoriously slow to respond to altered conditions. The simple fact of the matter is, however, that the US will not be able to go on buying goods at below their true cost in exchange for Treasury bonds which are likely to be worth substantially less as the dollar resumes its inexorable decline. The dollar will not, however, bear the full force of the adjustment and growth expectations will need to be cut back too.
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