If the US could only sustain a current account deficit of 1 percent of GDP in the medium term, for example, then the FEER for the dollar would initially need to depreciate by 5 percent compared to our central estimates. Over time the magnitude of this depreciation would slowly fall, because the lower deficit would reduce interest payments overseas, leading to a gradual reduction in the depreciation required to sustain this current account. Nevertheless, our calculations suggest that the FEER is very sensitive to our assumptions about medium-term current accounts. The second area of uncertainty in our estimates concerns the trade model we use. Equations for the volume of exports and imports are central to our model, but unfortunately they are not the most reliable macroeconometric relationships.
Japan provides a good example of the difficulties that can occur.
The 1990s have seen a substantial reduction in Japanese output growth. There are theoretical reasons for believing that this could be accompanied by a shift in Japanese trade, with more rapid import growth following an opening up of domestic markets, and a slowing down in exports as more production locates overseas. There was only marginal evidence for this effect in the data we had available, but nevertheless we did make some adjustments to our model to take account of this. If the adjustments we made were too little or too much, our estimates for the Japanese FEER could be significantly out, and there would be knock on effects on the other G7. Unfortunately it is almost impossible to know the magnitude of these structural changes before they occur.