Body
The US Federal Reserve has earned high marks for its transparent analysis of the US current account deficit and its unsustainability. But it has scored badly on pointing out the economic consequences and policy implications of its analysis.
As part of the inevitable correction of the deficit, the growth of total domestic demand must be slowed relative to the growth of domestic output. Americans will not enjoy curtailing the extent to which they are living beyond their means. The Federal Reserve must be part of the adjustment process in order to minimize this pain, and should say so now.
In June 2004, the Federal Open Market Committee agreed that the US current account deficit was unsustainable, but concluded: "Monetary policy was not well equipped to promote the adjustment of external imbalances, but could best contribute to maintaining an environment of price stability that would foster maximum sustainable economic growth." This remains the Fed's view, judging by recent speeches and research papers by its officials. It is an incomplete view.
As early as the late 1990s, Federal Reserve officials from Alan Greenspan, the chairman, down have warned that the US external deficit is unsustainable. The Fed should be applauded for its analysis of the issues. But too many Fed officials are cheerleaders for the view that adjustment will be smooth. Even if one is confident that this will be the case, it is another matter to assert that a correction of the US external deficit will probably be benign in its effects on financial markets.
The Federal Reserve has been disingenuous in not stating that adjustment will require that the growth of total domestic demand-principally consumption and investment-slows dramatically. Assume that the US current account deficit will be halved over the next three to five years from its current 6 percent of gross domestic product to 3 percent. To accomplish this, the growth of demand-4.4 percent over the past year, and three-quarters of a percentage point faster than the 3.6 percent growth of domestic output (GDP)-will have to be reduced by about 2 percentage points to three-quarters of a percentage point below the trend growth of potential output, which is about 3.2 percent. In other words, to about 2.5 percent or less.
This slowdown translates to $1,350 for every woman, man and child in the United States. And the inevitable adjustment of dollar exchange rates, in the order of 30 percent on average, will add an extra $1,000 per capita due to the adverse effects on the US terms of trade. The average price of US imports will rise relative to the average price of exports. No wonder politicians are staying away from this issue. The Federal Reserve does not have that excuse.
Fed officials have rightly observed that US fiscal policy has a role to play in the external adjustment by helping to correct the imbalance between US saving and investment. Tighter fiscal policy will also increase the probability that the adjustment will be smooth by damping the growth of demand. This is a point Fed officials have not made. Nor have they stated that FOMC policy can damp the growth of demand as well, and will have to do so vigorously to the extent that there is no assistance from the fiscal side.
Some may argue that a more rapid tightening of the considerable monetary accommodation that is still a prominent feature of the US economy would slow the growth of output. That may occur, but the slowdown will be greater if the adjustment is compressed into a shorter period because of the sharp decline of the dollar, perhaps precipitated by China finally adjusting the value of its currency. The Fed should take out insurance by changing what it says and does.
Others may argue that more rapid tightening of US monetary policy will short-circuit the external adjustment process via dollar appreciation. The evidence is that changes in relative short-term interest rates are not systematically correlated with changes in exchange rates.
Monetary policy is not just about managing domestic output and employment. It is also about managing total demand. Most importantly, it is about managing the balance between the two. A failure to anticipate the need to manage demand as well as supply as part of external adjustment is damaging Federal Reserve credibility. The Fed may have to slam on the brakes in order to slow the growth of domestic output as well as domestic demand to contain inflation. Starting at its meeting on Tuesday, the FOMC would be wise to prepare the US public and markets for this eventuality.
Commentary Type