Dec. 17 (Bloomberg) -- The U.S. current-account deficit narrowed in the third quarter to $178.5 billion, the smallest in two years, as the trade gap shrank and Americans earned more on overseas investments, a government report showed.

The shortfall, the broadest measure of trade because it includes transfer payments and investment income, was less than forecast and followed a revised $188.9 billion gap in the second quarter, the Commerce Department said today in Washington.

Expanding overseas economies and a drop in the value of the dollar helped shrink the deficit in goods and services. Federal Reserve policy makers, who last week cut interest rates for the third time in as many meetings, have said exports will help sustain growth through the housing recession.

``If the dollar stays weak, we should continue to see this improvement,'' said Francis Genereux, an economist at Desjardins Securities Inc. in Montreal, which forecast a deficit of $178 billion. ``The economies of the rest of the world are growing faster than the U.S. economy. U.S. imports are slower because the American economy is growing slower.''

The gap amounted to 5.1 percent of the economy, the least since the first three months of 2004, compared with 5.5 percent in the second quarter. The U.S. needs to attract about $1.96 billion a day to fund the gap.

International Demand

International buying of U.S. financial assets increased by a net $114 billion in October, the most in five months, according to a separate report from the Treasury Department. Overseas demand for American stocks and bonds has rebounded after credit-market turmoil contributed to record sales of long- term assets in August.

Economists forecast a third-quarter deficit of $183 billion, according to the median of 41 estimates in a Bloomberg News survey, from an initially reported $190.8 billion shortfall the previous quarter.

The deficit in trade, which accounted for most of the current-account imbalance, narrowed to $173.2 billion last quarter from $178.4 billion in the second quarter.

U.S. investors received more income on their holdings of overseas investments than foreigners received here. That helped to narrow the overall current-account deficit.

Income on overseas assets held by U.S. investors climbed to $205.6 billion from $195.5 billion. Foreign earnings on U.S. assets, including wages and other compensation, rose to $185.2 billion in the third quarter from $182.8 billion in the previous three months. That left a record $20.5 billion surplus on income payments, compared with a $12.7 billion surplus in the second quarter.

Government Payments

U.S. government payments to foreigners and other private transfers abroad registered a $25.8 billion deficit, compared with a $23.2 billion shortfall in the prior quarter.

The figures so far this quarter suggest the trade balance may continue to improve. While the gap widened in October on record crude oil prices, the balance excluding oil was the smallest since 2004.

Exports rose to the highest ever in October. Shipments of capital goods, including commercial aircraft and industrial engines, led the gain.

Morris Township, New Jersey-based Honeywell International Inc., the world's largest maker of aircraft controls, last week forecast higher 2008 profit as demand for plane parts and overseas sales help overcome a U.S. housing slump. Chief Financial Officer Dave Anderson said global economic growth will be ``in the high 2 to low 3 percent'' next year, with both the U.S. and Europe slowing to 1 percent to 2 percent.

Dollar's Influence

A cheaper dollar is helping to boost exports by making American-made goods less expensive to overseas buyers. The dollar was down 8.2 percent against a trade-weighted basket of currencies from its biggest trading partners in the 12 months ended in October, based on Federal Reserve data.

The drop in the dollar against major currencies since 2002 ``will help to improve our gaping trade deficit and thereby offset some of the otherwise contractionary effects of the tighter credit conditions,'' Fed Bank of San Francisco President Janet Yellen said in a speech in Seattle on Dec. 3.

Fed policy makers last week lowered the benchmark interest rate by a quarter point to 4.25 percent and took additional steps to encourage bank lending.

The U.S. economy will grow 2.2 percent this year and 2.3 percent in 2008, according to the median estimate in a Bloomberg News survey this month. The countries that use the euro as their currency will grow 2.6 percent this year, China will expand 11 percent and Mexico 3 percent, based on the median estimate of economists surveyed by Blue Chip Economic Indicators.

Net exports added 1.37 percentage points to third-quarter U.S. growth, the most since 1996.

``For the first time in many years, the trade sector has been a positive contribution to the U.S. growth, as opposed to a negative contribution,'' Fed Chairman Ben S. Bernanke said in congressional testimony Nov. 8. ``I think going forward we'll see additional strength coming from foreign trade.''

To contact the reporter on this story: Joe Richter in Washington Jrichter1@bloomberg.net

Last Updated: December 17, 2007 09:23 EST