The Dollars Fall and its implications

The U.S. dollar has depreciated by about 25 percent in real effective terms since early 2002, in what has been one of the largest sustained episodes of dollar depreciation in the post-Bretton Woods era. The largest previous such episode-where the dollar depreciated by over 30 percent in real effective terms-took place between 1985 and 1991, also against the background of a large U.S. current account deficit. In both episodes, the pace of depreciation was relatively gradual, with daily changes below 2-3 percent in nominal effective terms. In both cases, the US currency in broad terms moved in line with shifts in interest rate differentials. Moreover, in the earlier case, the dollar depreciation episode ended with the U.S. currency's level roughly consistent with broad, medium-term equilibrium, as per Fund calculations. Following the post-2002 decline, we assess that the U.S. currency today is the closest to its medium-term equilibrium value in a decade.

During the 1985-91 episode, the US current account deficit narrowed from a high of 3½ percent of GDP in 1987 to about balance in 1991. In contrast, the current episode has not been associated with a quick and sharp adjustment in U.S. current account balances. Indeed, in the recent episode, the current account widened initially to reach an all time high of nearly 7 percent of GDP in late-2005. It began to moderate only in 2006, and remained at around 5 percent of GDP in the first quarter of 2008. This modest shift has created doubts about the impact of exchange rate flexibility. However, when the change in the current account balance over the two episodes is deconstructed, accounting for some lags to adjust for the timing of the export and import responses to the depreciation, it becomes clear that two key factors are driving the difference in the behavior of the current account in the two episodes.

· The first is the oil trade balance. In the previous episode, the price of oil initially fell and then remained roughly flat in US dollar terms. This led to an very modest improvement in the oil trade balance of 0.1 percent of GDP between 1987 and 1991. By contrast, oil prices have risen rapidly over the past few years to a record high. Thus, between 2004 and 2008, the U.S. oil balance is expected to have deteriorated by 1.3 percent of GDP.

· The second key factor underpinning the difference in the current account behavior is the receipt of large transfers associated with the first Gulf War in 1991-amounting to as much as 0.7 percent of GDP. Similar transfers have not occurred in the current episode.

The implication is that, after stripping out the oil trade balance and war-related transfers, the change in the US current account between the two episodes in fact appears to have been roughly similar. The "underlying" current account (excluding oil and transfers) improved by 2.7 percent of GDP in the previous episode, compared with 2.4 percent in the current period. Moreover, in the earlier episode, the depreciation was more "front loaded", with the bulk of the depreciation occurring between 1985 and 1989. In the current episode, half of the depreciation has taken place since 2006. Given the long lags (up to 2 years) in the current account response to exchange rate changes, we expect to see further improvement in this "underlying" current account in the coming years.

-Perspectives on the Global Economic Landscape and the Role of the Dollar