Peterson Institute for International Economics

2009 Estimates of Fundamental Equilibrium Exchange Rates

When we first published our estimates of fundamental equilibrium exchange rates (FEERs) in July 2008 (Cline and Williamson 2008), we stated that this was intended to be a regular series of publications. This policy brief updates those estimates in light of the momentous changes in the world economy during the past year. Many of those changes, notably changes in actual exchange rates, should not influence FEERs, except insofar as we allow a range of variation of the target current account balance. But equally clearly, one does expect some of the changes, notably forecasts of the prices of oil and other commodities, to be important determinants of equilibrium exchange rates.

A major consequence of the global financial crisis has been a further rise in the already overvalued dollar, as investors have turned to the United States as a relatively safe haven. A larger overvaluation implies a larger external deficit, after the two-year or so lag from the exchange rate signal to trade flows. Similarly, the rise in perceived risk combined with the reduction in high domestic interest rates in some countries for countercyclical purposes has ended the “carry trade” and contributed to a strengthening of the yen in particular, reversing the currency’s gap from its previous estimated FEER, from a significant trade-weighted overvaluation in 2008 to a small undervaluation today. The extreme and unusually synchronized global recession has also caused major reductions in oil and commodity prices, a second potentially important cause of changes in FEERs. Finally, the most severe postwar global recession may have changed investors’ perceptions of long-term relative growth prospects across countries, although it is too early to judge this definitively.

As in Cline and Williamson (2008), we once again take as our point of departure the current account projections provided by the International Monetary Fund (IMF) in its 2009 World Economic Outlook (WEO). The WEO incorporates changes in the outlook for key commodity prices. The most important of these is the oil price, which the Fund assumes will average $52 a barrel in 2009 and $62.50 in 2010, and remain constant in real terms thereafter.

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Originally published at the Peterson Institute for International Economics.© 2009 Peterson Institute for International Economics. all rights reserved.

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