What should we make of the significant fall in the value of the US dollar in the last few weeks? Will this dollar weakness persist or be reversed in the months ahead and in 2007? How much will the still large and growing US current account deficit (measuring $225b in Q3 or an annualized $900b as announced today) put further downward pressure on the US currency? Structural, cyclical, market and technical factors all matter in making this assessment (see also the blog by Brad Setser today on the Q3 current account figures and trends)

The large, still growing and eventually unsustainable US current account deficit is the structural gravity force that will keep on weakening the dollar over the medium term. Indeed, since 2002 the dollar has been significantly weakening relative to floating currencies. This weakening of the dollar was temporarily interrupted and partially reversed in 2005 mostly due to cyclical factors: in 2005 the Fed was tightening while ECB and BoJ were on hold; US growth was perky and sharply outpaced that of Europe and Japan; the Homeland Investment Act (HIA) induced the repatriation of US MNC’s profits abroad at very low tax rates; US asset market – both equity and housing - were perky; and the Eurozone was buffeted by a whole bunch of political shocks (the defeat of the referenda on the new EU constitution; the intra-EU squabbling about its budget;  the inconclusive end of the German elections; the riots in France); the strong willingness of central banks to pile up dollar assets maintained the easy financing of at least 50% of the US external deficit. 

So, in spite of the force of gravity of a worsening current account deficit, these mostly cyclical factors lifted the dollar in 2005 and allowed it to levitate upward for a while. In 2006 these cyclical factors fizzled away: the Fed went into pause/stop mode while ECB and BoJ started tightening (more the former rather than the latter, thus explaining the still weak yen); US growth slowed down while it is accelerating so far in Europe and Japan; the HIA expired; the housing market started to go into a bust; political problems in Europe mellowed while they increased in the US (Iraq mess; loss of congressional elections by the Bush administration; feeling of lame duckness for this US administration); central banks around the world started signaling restlessness about piling up dollar assets at the same rate as in the past. So, it is no wonder that now cyclical and structural factors are pushing down the US dollar. How further down will the dollar go? One may want to distinguish between short-term trends and medium term ones...