Tuesday, February 20, 2007
Swervin’ Mervyn, all is forgiven. The Bank of England has come out with a couple of pearls over the past few days. In a submission to the Treasury Select Committee, the BOE noted that “some depreciation of the real effective exchange rate will probably be necessary” for the current account deficit to narrow. Amen, brother!
King also made some very interesting comments re: Japan last week. “I have some difficulty trying to understand why the call for Japan to ensure that its economy is growing as rapidly as other economies seem to be growing is consistent with saying that they should take a policy action to raise the exchange rate when that policy action would be likely overall to have the impact of slowing domestic demand growth.” Another gold star for Mervyn. Will tomorrow’s MPC minutes send the pound or short sterling shooting higher? Macro Man hopes for the latter but is slightly concerned that it will be the former.
Is the US dollar overvalued? There appears to be a broad consensus that this is indeed the case. After all, how can you have a $60 billion per month trade deficit without a drastically overvalued currency? Macro Man has no beef with the assertion that the dollar remains overvalued against the CNY, SAR, and other current account surplus countries.
However, on a broad trade weighted basis, the answer is not so clear. The dollar appears to be clearly undervalued against the euro on a PPP basis. Ditto sterling and the Canadian dollar. The Mexican peso is a bit trickier, given the periods of high inflation that the country has sustained in the past; however, Macro Man’s best estimate is that the US dollar is moderately undervalued against the MXN. And what about the yen? Macro Man estimates USD/JPY PPP at 110; a moderate overvaluation, perhaps, but one that would appear justified by interest rate differentials and capital flows.
On a broad basis, Macro Man could construct an argument that the dollar is actually undervalued. What would we expect to see from an undervalued currency? Surely that exports would rise substantially faster than imports. In fact, that is exactly what has happened in the US once oil imports (which are price inelastic in the short run) are stripped out. The effect has been masked because the stock of US imports is so much higher than the stock of exports, so exports have to grow substantially higher than imports just to keep the trade deficit constant. That is exactly what’s happened. As the chart below indicates, export growth has been at its strongest level vis-à-vis imports since the current trade data series began in 1992.
Even if we include oil imports, export growth is outstripping import growth at its fastest rate since 1991 (goods only pre 1992). That trade improvement was the result of a retrenchment in domestic demand. This one? It could well be the exchange rate. This of course begs the question of how much improvement would be required to sate the bloodlust of the professional worriers. Anyone with thoughts on the matter, answers on a postcard please!