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The latest budget forecasts from the US Council of Economic Advisors provide a stark reminder of the dollars potential structural deficiencies. The intensification of the dollar decline of the past 2 years appears to have primarily emerged due to cyclical reasons, such as US economic growth rates and interest rates underperforming those of the G7. The contrasting monetary policies between the US and Europe prevailing during most of 2006 and 2007 were an event not seen since the early 1990s.
Mondays budget projections from the CEA for a record high deficit in 2009 may potentially place the dollars structural weakness back in play. The 2008 fiscal deficit forecast of $289 billion equals 2.7% of GDP based on a GDP growth of 1.6%, while its 2009 fiscal deficit estimate of $482 billion is equivalent to 3.3% of GDP based on a 2.2% GDP growth projection for 2009. CEA Chairman Lazear said of the 2.2% GDP growth forecasts We believe that that is a realistic forecast ¦that we should be back on track.
While the CEAs forecast agrees with the Feds 2.0-2.8% forecast, it diverges from the IMFs latest revision to 0.8% from the initial 1.0%. If investors took the middle ground between the Feds 2.2% and IMFs 0.8% and came up with about 1.0% GDP growth, then the fiscal deficit would stand at 3.5%, thus, matching the 2004 high. Considering estimates for a declining current account deficit toward 4.9% and 4.7% of GDP in 2008 and 2009, the total twin deficits (budget and current account) may be expected to near 7.5-8.0% of GDP in 2009. Although this total stands below the twin deficits of 2003-2005, its implication for the dollar remains significant to the extent that foreign investors face a wide choice of alternatives to US dollar investments, such as commodity-based opportunities in Brazil, Australia or East Asia. The credit crisis in the US, the deteriorating state of US GSE bonds and rising inflation appear to have inflicted severe damage in US paper, which is widely considered to be a crucial element in drawing foreign deficit financing. Because of this, higher US interest rates may be required to maintain foreign flows into the US. But should the twin deficits surge anew and US interest rates remain at current levels (or fall further), this could be a distasteful recipe for the US dollar.
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