Trade and the Dollar
Our trade deficit is narrowing, with exports growing at four times the pace of imports. In September 2007, the U.S. deficit in goods and services trade was $677.4 billion (annual rate), down substantially from its recent peak of $811.3 billion in August 2006. In the third quarter of 2007, strong exports contributed nearly 2 percentage points to real economic growth, a welcome offset to weak residential investment. Strong export growth is likely to continue through next year because of strong growth abroad and the dollar’s depreciation.
A key factor contributing to lower U.S. trade deficits is phenomenally strong economic growth abroad relative to that in the United States. The slower pace of U.S. growth this year has trimmed import demand. Growth next year will probably show only a little improvement. World growth, in contrast, is well above its average pace, and the number of countries sharing in that growth is the largest in most observers’ memories. Holding all else constant, when foreign growth exceeds U.S. growth by at least one percentage point, our trade deficit often shrinks. Foreign growth has outpaced U.S. growth since 2004 and is likely to do so this year and next. The big uncertainty, of course, is the possible global fallout from the U.S. subprime implosion.
The U.S. trade deficit is getting a boost from the dollar. The relationship between dollar depreciations and the U.S. trade balance has never been simple and clear-cut, because it depends critically on why the dollar depreciates. The dollar has been depreciating since early 2002. Initially, the depreciation seemed to reflect aggregate demand pressures emanating from the United States. Such a home-grown depreciation would not result in a lower trade deficit. Since 2006, however, a growing reluctance among international investors to add dollar-denominated assets to their portfolios seems to be driving the dollar down. The Federal Reserve’s rate cuts in September and October encouraged these portfolio adjustments. This diversification will lead to a lower trade deficit if not confounded by inflation fears, and thus far, the federal funds rate cuts have not had a significant effect on inflation expectations.
A dollar depreciation in response to an international portfolio shift out of dollars raises the dollar price of goods produced abroad and lowers the foreign-currency price of goods manufactured in the United States. This relative price change shifts worldwide demand toward the United States and, if inflation remains subdued, will reduce the U.S. trade deficit.