Impact of the Lower Dollar and Higher Oil Prices on the US Current Account Balance

November 1, 2007

In September I updated my current account projection model from a 2005 base to a 2007 base (Cline 2007, 2005). The dollar has fallen significantly in the two months since those estimates were prepared. In the same period, and perhaps not fully coincidentally, oil prices have surged to nearly $100 per barrel. This note considers which effect is the more dominant: current account improvement from further dollar correction or current account deterioration from higher oil prices. Oil turns out to be slightly more important, if the price remains high at about $100.

At the time of my September 2007 estimates, the Federal Reserve’s broad real index for the dollar (March 1973 = 100) stood at 90.6, down from an average of 96.7 in 2006. By November 7, 2007, the Fed’s broad real index had fallen to 86.3. This means that the dollar now stands close to its two all-time troughs on this index, which were 84.0 in October 1978 and 84.2 in July 1995. The trade-weighted real value of the dollar has fallen 10.8 percent from the 2006 average. Against the peak full-year level of 110.8 in 2002, the broad real dollar has fallen 22.1 percent.

The acceleration of the decline is noteworthy. The dollar has fallen by about the same proportion in 2007 alone as it fell during the four years 2003–06 (about 11 percent in each case). The recent decline of the dollar seems closely related to eroding foreign confidence in the face of more severe than expected losses by major US financial institutions from the subprime mortgage problem, as well as to the recent reduction in US policy interest rates.

My September update found that the baseline current account path had improved somewhat from a deficit of about 7–71/2 percent of GDP in 2010 estimated in my 2005 book to only 5.1 percent in 2010 and 5.4 percent in 2012. The narrowing of the deficit baseline was attributable in part to a decline in the dollar by about 6 percent from the base used in the 2005 projections. The improvement also reflected somewhat lower prospective US growth and hence import expansion, as well as a much more favorable position for net international liabilities than previously expected thanks mainly to large increases in prices of equity owned abroad in 2005–06.