The new Fed’s Chairman, Ben Bernanke, is expected to steer monetary policy towards inflation targeting. How will this affect the dollar’s strength and the sustainability of the trade deficit? (Blake Irving, Boston, MA, USA)

It’s likely that Fed Chairman Bernanke will in the short term follow a course that appears very similar that followed by Alan Greenspan. Formal adoption of inflation targeting, even if it is implemented, is probably not going to look too different from current policy - especially if the target is expected future inflation.

To the extent that the economy seems to be accelerating in 2006q1, and inflationary pressures (as measured by the core CPI) seem to be mounting, it is likely that U.S. interest rates will continue to rise. This will probably lead to a strengthening dollar as long as the short rates are seen as rising. Over the longer term, the dollar will likely weaken as policy rates in the Euro area, the U.K. and Japan rise, and as the financing requirements associated with the U.S. current account deficit become ever larger.

After surviving the dot-com bubble, the US economy now has to solve the real estate bubble. Reading SmartEconomist.com’s report on your study I fear that real estate deflation could bring about a recession large enough to restore the US trade balance. Do you agree? (Julie Sanders, Atlanta, GA, USA)

A decline in housing prices would be expected to depress consumption; the standard estimate is that each dollar’s decline in household net worth induces about a 5 cent decrease in consumption.

While the growth rate of consumption will likely decline, that need not necessarily result in a recession. It may be that net exports (which is part of GDP) will pick up the slack. What is probably true is that U.S. GDP growth will need to decline relative to growth in Europe and Japan - just like what happened during the mid-1980’s adjustment of the U.S. trade balance.

With energy prices soaring, and expected to remain high in the long run, is energy becoming a dominant factor in determining global trade imbalances? (Jovan Kovacevic, Sydney, Australia)

It is clear that in the 2004-05 period, the current account surpluses of the oil producing countries have risen in importance, and now rival in impact the effects of the East Asian surpluses (see for instance the discussion in last September’s World Economic Outlook, published by the IMF). An important question is how durable these imbalances will be. It may be that as time progresses, the OPEC nations and Russia are able to increase consumption and investment sufficiently to reduce these surpluses. But until that happens, both the surpluses, and how these countries allocate their savings (i.e., in dollar versus euro versus other currencies) will have a tremendous impact.

How will China’s growth affect the sustainability of the US trade deficit? Will politics or economics be more important in deciding whether we can afford our trade deficit in the years to come? (Yishay Abramoff, New York, NY, USA)

I think that China’s bilateral trade surplus with the United States is a minor macroeconomic issue, but a major political issue. That is because even if China were not running a trade surplus with the United States, somebody else would be - either Korea, Japan, India or even Europe. The U.S. trade deficit is primarily the outcome of savings and investment trends in the United States - and to the extent that the relevant savings include the government’s budget balance, most of our trade deficit is American made. The politics come into play in the sense that the Chinese bilateral deficit is an easy focal point.

My view is that Chinese growth, if complemented by continued development of the financial system so that Chinese households can borrow more easily, will inevitably lead to a smaller U.S. trade deficit. But that day may be far off, particularly in light of imminent protectionist pressures in Congress, so in the short to medium run, fiscal policy in the U.S. is the only plausible way to ensure the U.S. trade deficit moves toward a more sustainable path.

Your study suggests that the exchange rate alone will not cure the US trade deficit. However, a sharp dollar devaluation might hurt countries exporting to the United States, China in the first place. Isn’t your analysis missing the political perspective on these issues? (Mary Chang, Hong-Kong, Hong-Kong)

My study was primarily descriptive, rather than prescriptive. I would not advocate an exchange rate depreciation, sharp or otherwise, on the basis of these results. What I wanted to show here was that if an exogenous reduction in capital inflows occurred, either the dollar would have to fall substantially, US income would have to fall relative to foreign, or some combination of the two.

On the other hand, in other instances (see the PDF document “Getting Serious about the Twin Deficits”, Council on Foreign Relations Special Report No. 10), I have suggested that continued dollar depreciation is a necessary adjunct to fiscal policy realignment, if the goal is to shrink the magnitude of the world’s current account imbalances.

If Asian countries stopped buying dollars for their reserves, would this force the Fed to accept much higher interest rates, thus fuelling a recession? Would there be anything that the Fed, or the Congress, could do to avoid this scenario? (John Grapper, Minneapolis, MN, USA)

If East Asian central banks stopped buying dollars, either interest rates on U.S. dollar denominated assets (e.g., Treasury bond yields) would have to rise, or the dollar will have to decline (resulting eventually in a smaller current account deficit). The Fed might decide to resist the dollar decline by raising interest rates, but if it adopts an inflation targeting framework, then such developments might be of subsidiary importance. Hence, a recession is not a necessary outcome in this scenario; it’s dependent upon a whole set of factors.

That being said, if the official sector and private investors cease to lend to the U.S., then, by virtue of the fiscal profligacy of the last five years, there is little the Congress could do to avert a slowdown. More borrowing in such conditions will only lead to higher interest rates, exacerbating the situation.

In your study you argue that the dollar’s exchange rate has only a limited impact on the trade deficit, which depends mostly on the economic cycle. Do you think the current US fiscal policy is going to lead us towards a prolonged recession? Is this a consequence of the budget deficit created by the Bush administration? (Ross Watson, San Josè, CA, USA)

I am not certain that the fiscal policies pursued by the Bush Administration will necessarily lead to a prolonged recession. However, I am confident that the U.S. standard of living will be lower in the future than it would have been in the absence of such irresponsible policies. More importantly, I think the Bush Administration deficits and the resulting accumulation of government and foreign debt places the American economy in harms way. Essentially, we have made the U.S. economy hostage to the whims of households and governments in the rest of the world. If there is a shock to the system, the US may very well suffer from the economic disruption; the rest of the world, especially emerging markets, may suffer even more.

I discuss this issue at greater length in Econbrowser, the weblog I contribute to.

Do you expect that the US and the European central banks will cooperate or compete in putting pressure on the Chinese authorities for a revaluation of the renminbi? (Bertrand Noisée-Chantery, Paris, France)

Since both the Europeans and the U.S. have an interest in Chinese currency appreciation, I don’t expect competition, although cooperation might be too strong a word. Rather, they might coordinate to make sure mixed messages are not sent.

Some press commentators argue that the trade deficit could bring the dollar to drop so much that we would go into a recession. But I believe a fall in the dollar would be a positive force for the export industries. Is this correct? After all, the dollar also depreciated sharply in the late 1980s, and that helped the economy. (Miguel Cruz, Santiago, Chile)

You are correct that export industries and import competing industries will both benefit, at the cost of nontradable sectors (construction, some services) from a sharp dollar depreciation. But a recession, or at least a growth slowdown, is possible. In the very short term, when prices of imports and exports rise and quantities are little changed, the immediate effect is a deterioration in the real trade balance, and hence a contraction in aggregate demand. (this is called a contractionary devaluation in the lingo of emerging market economics). Even in the longer run, when price elasticities are presumed to be larger (in absolute value) so that the Marshall-Lerner condition holds, the fact is that U.S. imports are so much larger than exports ($2.1 trillion versus $1.3 trillion in 2005q4). Hence, the depreciation may still be contractionary in impact.

If I understand correctly, your study points to the special role that IT prices played in the 1990s. Do you expect your conclusions to change as globalization renders tradable services which were previously mainly domestic, and these services take a large chunk of the trade balance? (Edward Wilklington, London, England).

Services are indeed becoming more tradable. But services are still a small proportion of total trade, and growth in such trade is dependent upon progress in the General Agreement on Trade in Services component of the WTO. To put things in perspective, the services proportion of U.S.exports have risen from 26% in 1967 to about 30% in 2005. The services proportion of U.S. imports have actually fallen from 30% to 16%.