Exchange Rate Realignments and Risks of Deflation in North America

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United States

The US dollar has strengthened in recent months against most major currencies, with the exception of the yen. It has also gained strength against emerging market currencies, and the US effective exchange rate has appreciated by just over 7 per cent in the past three months. Emerging market declines have been exacerbated in recent weeks by the turbulence on financial markets that has forced stock markets to interrupt trading on several occasions. Figure 13 shows effective exchange rates for the US, Canada, Mexico and Brazil. Central banks in Mexico and Brazil have intervened in currency markets in recent weeks to stem the decline of their currencies, which have dropped against the dollar by nearly 20 per cent in the case of Mexico and 40 per cent in Brazil since the beginning of September. If stock market trading stabilises, much of these losses should prove temporary. Our forecast assumes that a depreciation of 10 per cent in effective terms in the Brazilian real and 5 per cent in the Mexican peso is sustained. While this raises the inflationary outlook for these economies, gains in competitiveness will help moderate the impact of the global recession on Latin American economies. However, a more sustained depreciation will put the banking systems in these countries at risk as it becomes increasingly difficult to service debt in foreign currency.

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In the second and third quarters of 2008, the US appears to have staved off a decline in output, primarily due to a strong positive contribution to growth from net exports, which added 0.7 percentage points to GDP growth in the second quarter and is expected to have added another 1/2 point to growth in the third quarter. This was effected through a sharp contraction in import demand, effectively exporting the US recession to the rest of the world, and we saw output decline in the second quarter in Japan, Germany, France and Italy as a result. However, the recent appreciation of the US dollar and weaker demand from the rest of the world suggest that the US will no longer be able to rely on exports to sustain the economy, and we see an 87 per cent chance that the US will experience a recession in the next few quarters, with a strong probability that the recession will be prolonged for up to four quarters (see figure 1 on p. 75).

The strong GDP growth observed in the second quarter of this year was also supported by monetary policy action in the first quarter, and by fiscal measures implemented in the second half of 2007. Consumer spending increased by 0.3 per cent on a quarterly basis, and this relatively favourable outturn resulted from increases in personal incomes reflecting enhanced social benefits and tax rebates paid within the fiscal stimulus package. The scale of the increase in spending would suggest US consumers react rather more to current incomes than the theory behind 'forward looking consumers' in figure 11 would suggest. The fiscal stimulus seems, however, to have provided only a temporary boost to consumption, (7) and consumer spending declined in July and August. We forecast a rise in consumer spending in 2008 as a whole of just 1/2 per cent, with spending expected to contract sharply next year.

Private investment continues to slide. In the second quarter, housing investment dropped by 3.5 per cent on a quarterly basis, and further declines are forecast for the next several quarters. The level of housing investment expressed as a share of GDP continues to fall, and we expect that this ratio will fall to 2.4 per cent next year, compared to a long-term historical average of 4.5 per cent and the recent peak of 5.5 per cent in 2005. House prices fell by a further 1.4 per cent in the second quarter and a decline of similar magnitude is believed to have continued in the past three months.

The weaker than expected performance of the real economy has been accompanied by worrisome developments in the financial sector. …