January 26, 2004

After the November report of a record trade deficit was released, economists rapidly reduced their forecasts of fourth quarter economic activity.  At the same time, they began talking about the J-curve.  Why did one report create such a response?

First, let me explain what is meant by the J-curve.

Usually imports are committed for a whole sales or production run depending upon whether the goods are for final use or will be part of another product. Thus, a price change does not immediately impact the flow of imports.

However, a sustained drop in the value of the dollar means that more dollars must be earned from each imported good to pay for the euro, yen, pound, or other production costs that were used to create that good. Indeed, import prices other than for petroleum rose more than 4 percent in 2004. Moreover, prices accelerated to more than a 6 percent rate of increase in the last two months.

If the units being shipped are unchanged but the dollar prices are rising, the total dollar value of imports also are rising. Thus, a drop in the value of the dollar against other currencies initially means higher imports. After the sales or production cycle is completed, some of those now more expensive imports may be replaced by domestically produced goods. When that occurs, falling import volumes begin to lower imports.

Assuming exports remain unchanged, that initial price increase raises the trade deficit before lower units imported begins to reverse that trend and lower trade deficits. This pattern of rising followed by falling trade deficits caused by currency changes forms a leaning J.

If only the J-curve was creating the growing trade deficits, economists would not be scurrying to reduce their fourth quarter forecasts. Unfortunately, just as imports were rising because of currency induced price increases for imports, exports unexpectedly plunged.

An apparent slowing in world growth reduced desires to buy American capital equipment and American industrial materials.Hopefully, this export shortfall is temporary. Strong production of equipment in December along with solid gains in worker hours suggests that export sales rebounded in December.

Nevertheless, the initial report on GDP will not include those December trade figures. Indeed, they may not fully capture the surge in after Christmas sales that saved Christmas for many retailers.( The initial sales report notoriously under-reports sales for the last ten days of the month.) Therefore, GDP growth might be reported as 3.5 percent or even less in the initial report.

Industrial production actually grew by almost the four quarter average of 4.2 percent in the fourth quarter. This is decidedly faster than the 2.7 percent gain in industrial production at annual rates during the summer. Therefore, I am almost certain that the export plunge in November was a one month phenomenon. Even so, we might still see higher trade deficits in February, when a rebound in energy prices adds to the cost of petroleum imports. After that, the favorable impact of the J curve should begin to surface. Coupled with prospects of lower petroleum prices, at least in my outlook, we should soon put those record trade deficits behind us.

Will that also mean that the weak dollar is going to go away?

While trade deficits certainly must be financed by international investors holding an equivalent increase in our financial and/or real assets, they may be more than happy to do so.

What if expected investment returns are better in the United States than elsewhere? Investors would come flocking to our shores. Indeed, the trade deficit could be needed to provide enough assets to meet the insatiable desires of those investors. However, a weak dollar suggests that international investors are receiving more assets than they willing wish to absorb. If the dollar remains weak (but it has rallied against many currencies since the year began), then investors will increasingly avoid losing more of their own purchasing power when they purchase dollar based assets. Indeed, a dollar route could develop.

That dollar plunge still is possible. Nevertheless, if trade deficits begin improving, as I expect by spring, the dollar may very well stabilize near current levels against most currencies, which is exactly what I am forecasting for this year.

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