Dollar exchange rates have recently reached some eye-bulging levels: parity with the Canadian dollar, a record against the euro, and a rate not seen in 25 years against the British pound. Two fundamental developments seem to be pressing on the dollar: One is a large current-account deficit and the other, recent changes in monetary policy.
The dollar has been depreciating in an orderly fashion since February 2002. Many economists viewed this depreciation as a natural market adjustment to persistent and growing U.S. current-account deficits. The United States has maintained a current-account deficit in all but one year since 1982. During the first half of this year, our current-account deficit was running at a $776 billion annual rate, equal to nearly 5.7 percent of our GDP. This ratio has narrowed slightly from 6.2 percent in 2006.
The United States pays for its current-account deficits by issuing financial claims—corporate bonds and stocks, Treasury securities, bank accounts, etc.—to the rest of the world. Essentially, these instruments are promises to pay for our existing surfeit of imports out of our future output. Beginning in 1986, foreign claims on the United States began to exceed U.S. claims on the rest of the world. At the end of last year, the net outstanding stock of foreign financial claims on the United States—our negative net international investment position—amounted to $2.5 trillion dollars, or 19.2 percent of our GDP.
Because our negative net international investment position represents foreign claims on our future output, economists often express it as a ratio to GDP and interpret this ratio as a gauge of the economic burden of these claims. The stock of foreign claims on the United States has been growing over the years from 6.3 percent of GDP in 1996 to 19.2 percent of GDP last year. If recent projections of our current-account deficit prove accurate, our negative net international investment position could easily remain around 20 percent of GDP this year and next. This is a hefty percentage, but it is not unprecedented among large industrialized countries.
To be sure, net foreign claims cannot rise indefinitely relative to our GDP. At some point, international investors will become reluctant to add U.S. financial claims to their portfolios without some inducement for the growing risk of doing so. Such a risk premium could come about either through higher interest rates on dollar-denominated claims or through a depreciation of the dollar, which would lower the foreign-currency price of dollar-denominated assets, or from a combination of both of these adjustments. Unfortunately, economists have no way of knowing when this effect might take place or how abruptly the adjustment might occur.
The risk-premium story does not seem to explain dollar movements between early 2002 and mid-2006. Over that time period, the dollar depreciated as the current-account deficit increased, a pattern more consistent with expanding U.S. aggregate demand than with the risk-premium story. Nevertheless, since mid-2006 statistical evidence and anecdotal news reports have suggested that international investors are becoming increasingly reluctant to add dollar-denominated assets to their portfolios. International Monetary Fund data on the currency composition of international reserve holdings, for example, suggest that developing countries are adding more euro-denominated assets to their portfolios than dollar-denominated assets. Foreign investors, however, have not been dumping dollars outright.
Since mid-August, the pace of the dollar’s depreciation has accelerated. The market observed the Federal Reserve respond a bit more aggressively than many other central banks to the widening turmoil in financial markets. Although some foreign central banks provided emergency liquidity to financial markets, none of the key central banks—the European Central Bank, the Bank of England, the Bank of Japan, or the Bank of Canada—cut their main policy rates. Prior to the recent market disorder, policy analysts believed that these central banks, notably the European Central Bank, were more likely to raise rates than lower them. While the recent financial turmoil has muddied the near-term outlook for economic activity in many countries, analysts still do not seem to anticipate a loosening of monetary policy abroad. The Federal Reserve, on the other hand, first narrowed the spread between the primary credit rate and the federal funds rate and then lowered the federal funds rate by 50 basis points (from 5.25 percent to 4.75 percent). This was a bigger cut than many observers expected.
The relative shifts in policy seem to have had two effects on dollar exchange rates. First, the yield on short-term U.S. financial instruments declined relative to the yield on short-term European paper, generally making foreign investments relatively more attractive. As investors move out of dollars and into euro-denominated or pound-denominated assets, the dollar exchange rates will fall. By itself, this effect should appear as a fairly discrete adjustment. Second, if the easing of U.S. policy causes individuals to expect a higher rate of inflation in the United States than elsewhere around the globe, the downward pressure on the dollar will be even greater.