What does the growing US trade deficit mean?

The improvement in the trade deficit from June (USD 55bn) to July (USD 50bn) was largely reversed in August, with a resumption of the widening trend to the tune of USD 54bn in the month. That figure was higher than we expected of USD 51.4bn, although we had warned that the risk was to a wider deficit thanks to higher oil prices.

Relative to July, exports rose a meagre 0.1% to USD 96.0bn after a 3.0% monthly rise in July. Imports, on the other hand, increased 2.5% in August to USD 150.1bn, following a 1.1% decline in July. Since February of this year, both exports and imports have risen by double digits on a y/y basis each month.

The August trade deficit was still shy of June's record trade deficit (USD55.0bn), but it is close. Add to that what seems like an inexorable grind higher in world oil prices and strong US growth for the rest of 2004 and into 2005, especially relative to its major trading partner Europe, and one concludes that the outlook for the nominal USD value of the trade deficit going forward is not too promising.

The result, of course, is worry about the precariousness of the USD and the market turmoil that could be caused by its possible disorderly decline. While we certainly see little sign of this before the Presidential election, options markets look complacent with implied volatilities currently abnormally low across the curve, especially when considering the risks of a post-election USD sell-off.

One important factor to note is that much of the increase in the August trade deficit came in the form of higher import prices, particularly oil. For example, import prices rose 1.4% in August, but import prices excluding petroleum rose only 0.3% and the price index for petroleum imports rose 8.6%. Looking at the y/y figures, import prices ex-petroleum rose 2.9% y/y, down from 3.1% in July and up from 1.2% at the end of 2003. That reflects some pass-through to import prices from the weaker USD, but overall the effect seems tame. The series for import prices for petroleum shows another story however. On a y/y basis, they were up 39% in August from 12.8% y/y at end-2003, but there is much volatility from month to month. (Please see the chart.)

One important implication of the fact that price effects account for much of the higher deficit means that the drag on Q3 GDP growth from the trade deficit is likely to be lower than it was in Q2. In fact, the August trade numbers do not lead us to change our outlook for Q3 growth. For example, the trade deficit subtracted nearly 1.1% from the headline Q2 GDP growth figure, the biggest reduction since Q4-02. In Q3-04, that figure is likely to be much smaller, in the neighbourhood of -0.4% because of the price effect. Therefore, the expectation for the economy to emerge from its soft spot and for the Fed to continue raising interest rates remains unchanged.