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United States and the IMF
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On July 30, 2003, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with the United States.1
After experiencing one of the largest stock market declines in the post-war period and then falling into recession in March 2001, the U.S. economy was buffeted by a series of further shocks, including the September 11th attacks, major corporate failures, additional stock price declines, and the war in Iraq. Remarkably, the recession was mild and short-lived, with output declining only ½ percent in the first three quarters of 2001.
The recovery, however, has been uneven and sluggish. Growth slowed markedly at the end of 2002 and early 2003, the unemployment rate jumped to just over 6¼ percent in June 2003, and the output gap has widened. Reflecting these developments, the core CPI inflation rate has drifted downward to under 1½ percent, a level not seen since the mid-1960s—prompting concern in early 2003 of the risk of deflation.
Both monetary and fiscal policies have provided unprecedented support to the recovery. The target for the federal funds rate was reduced by a cumulative 475 basis points during 2001, a further 50 basis points in November 2002, and an additional 25 basis points in June 2003. The dollar's depreciation since early 2002, the decline in long-term interest rates, and the more recent firming of stock prices have also helped ease financial conditions.
On the fiscal front, substantial reductions in income tax rates were legislated in June 2001; March 2002 legislation increased investment incentives and extended unemployment benefits; defense and security-related spending was increased significantly in 2002 and 2003; and substantial additional tax cuts were legislated in May 2003. These measures contributed to a massive shift in the federal government's unified budget balance, from a surplus of 2½ percent of GDP in FY 2000 (October-September) to a deficit likely to exceed 4 percent of GDP in FY 2003. With the economic slowdown also weighing heavily on revenues at the state and local level, the combined balance of the general government could reach a deficit of 6 percent of GDP in 2003.
Against this background, household demand has remained resilient. Reflecting the effects of low interest rates, the boom in home prices, and strong growth in disposable incomes, both consumption and residential investment have provided valuable support to domestic demand. At the same time, households were able to boost their saving rate—which had fallen to around 2 percent prior to the recession—to around 3½ percent in early 2003.
By contrast, business fixed investment, which had plummeted from historical highs relative to GDP during 2000-01, has been much weaker than in past recoveries. Business equipment and software purchases had begun to rebound somewhat in the last three quarters of 2002, but have since softened, while a sharp increase in industrial vacancy rates has continued to weigh on nonresidential structures investment.
Nonetheless, productivity growth has remained robust and financial market confidence has improved. This partly reflected aggressive labor shedding in 2002, which helped yield a 2 percent decline in unit labor costs and a 4¾ percent surge in productivity—the fastest annual rate in over 50 years. As a result, profits have begun to recover and the increased risk aversion triggered by accounting scandals and the uncertainty during the buildup to the Iraq war appears to have eased considerably. Reflecting improved confidence, equity markets have rallied since April and bond spreads have narrowed.
However, weak demand abroad and the earlier strength of the U.S. dollar have weighed heavily on the economy. Export volumes began to recover modestly in 2002, but fell again toward the end of the year and in early 2003 and remain at a low ebb. By contrast, import volumes rebounded strongly in 2002, reflecting purchases of consumer goods and industrial supplies. These factors, as well as higher world oil prices, helped to push the current account deficit to a record 5¼ percent of GDP in 2003Q1. With less favorable interest rate differentials and weaker global sentiment toward U.S. equities, private capital inflows fell. Although this was offset by slower investment abroad by U.S. residents and increased purchases of U.S. dollar assets by foreign central banks, the dollar depreciated in nominal effective terms by around 15 percent between February 2002 and June 2003.
The staff projects activity to gather momentum in the latter half of 2003, with GDP growth rising from around 2¼ percent in 2003 to 3½ percent in 2004. Consumer sentiment has improved with the quick end to the Iraq war, and household demand would be further supported by additional tax cuts, the rebound in stock prices, low interest rates, and the easing of oil prices. These same factors, as well as strong productivity growth, are also expected to allow profits and business fixed investment to gather strength into 2004. The drag from net exports would wane into 2004, reflecting gradual recoveries abroad and the lagged effects of the dollar's depreciation, and the current account deficit would start to narrow somewhat from around 5 percent of GDP in 2003. With economic slack remaining significant, headline CPI inflation is projected to fall to around 1¼ percent in 2004, before rebounding somewhat as the output gap closes.
Executive Board Assessment
Executive Directors highlighted the valuable support that the U.S. economy has given to global growth, reflecting the economy's remarkable resilience and flexibility in the face of severe shocks, and the exceptional stimulus provided by U.S. monetary and fiscal policies. Directors welcomed the recent signs that the recovery appears to be gathering momentum, with improved prospects for stronger growth in the second half of 2003 and into 2004. At the same time, however, they noted that the recovery has thus far been uneven, and that downside risks remain. These risks reflect uncertainties regarding the strength of business investment, the extent to which adjustments associated with the unwinding of the equity price bubble have fully run their course, and the support that can be expected from the global environment. Many Directors also pointed to possible developments, especially in the housing market, that might affect the strength of household demand.
Looking ahead, Directors agreed that the long-term growth prospects for the U.S. economy remain strong, supported by its flexibility, which has contributed to high productivity growth in recent years. They stressed, however, that for the economy's full potential to be realized, decisive action will need to be taken over the coming years to re-establish a strong U.S. fiscal position. In particular, they expressed concern that the worsening of the longer-term fiscal position, including as a result of the recent tax cuts, will make it even more difficult to cope with the aging of the baby-boom generation, and will eventually crowd out investment and erode U.S. productivity growth.
Against this backdrop, Directors saw as priority for the U.S. authorities to manage carefully the risks to the recovery, while establishing a credible approach for dealing with the longer-term fiscal problem. They underscored that an effective response to these challenges will also help ensure that the U.S. economy continues to play a key role in supporting sustainable global growth, and avoid placing undue pressure on global saving and interest rates.
Directors commended the Federal Reserve for its strong and proactive response to the economic slowdown. Most Directors saw scope for further easing if disinflationary pressures are not arrested, and welcomed, in this regard, the authorities' readiness to take further action if needed, including by using a broader range of policy instruments. A number of Directors considered that a quantified statement by the Federal Reserve of its medium-term inflation objective could help anchor inflation expectations even more firmly and strengthen policy transparency, especially in the present situation of very low interest rates and concerns about possible, albeit remote, deflation risks. A few other Directors, however, observed that a more specific statement of inflation objectives is unnecessary as a practical matter, given the clear statement of intentions by Federal Reserve officials, and cautioned that a more specific statement of an inflation objective might erode the authorities' credibility in the absence of instruments to achieve with precision a particular inflation target.
Directors considered the depreciation of the dollar during the past year to be consistent with monetary easing and with the longer-term need to bring the U.S. current account deficit to a more sustainable position. Some Directors noted, however, that the impact on the current account could be relatively modest since the dollar had depreciated against the currencies of only a limited set of U.S. trading partners. Directors underscored the importance of continuing to ensure a cooperative approach toward the orderly adjustment of the U.S. current account deficit. This would need to involve disciplined fiscal policies in the United States to help strengthen national saving, as well as strong efforts among U.S. partner countries to promote sustained growth.
Directors considered that the authorities face significant challenges in ensuring the long-term sustainability of the fiscal position. Although the deficit-to-GDP ratio is projected to narrow in coming years, the projections assume a substantial improvement in tax receipts and strict limits on discretionary outlays, both of which would mark a sharp turnaround from recent developments. The risks to the fiscal outlook appear especially worrisome given the significant actuarial deficit arising from the longer-term demographic pressures on the Social Security and Medicare systems.
Against this background, Directors again urged the authorities to establish a credible fiscal framework, with the clear objective of returning the budget to balance, excluding Social Security, over the next five to 10 years. By helping to reduce the debt ratio ahead of impending demographic pressures, this framework would provide room to phase in the reforms that are needed to place retirement and health care systems on a sound financial footing. To help ensure the sizable fiscal adjustment over the medium term, Directors stressed the need to contain spending growth, and they welcomed the authorities' intentions in this regard. They also underscored the importance of carefully reviewing tax priorities, given the considerable uncertainty surrounding the future revenue outlook and path of tax rates. In this context, some Directors specifically recommended measures to increase the tax effort to support the fiscal adjustment. A few Directors encouraged the authorities to consider energy-related taxes, which, in addition to helping to align energy supply and demand and curb emissions, could contribute to strengthening the fiscal position.
Directors welcomed the assessment of the fiscal transparency Reports on Observance of Standards and Codes that the United States sets high-level or best practice standards in most areas of fiscal transparency. However, in some respects—in particular, the extensive use of sunset clauses on tax cuts and the omission of some significant costs from recent budget projections—most Directors noted that fiscal transparency appears to have weakened in recent years. Directors welcomed recent plans to strengthen expenditure discipline and encouraged the authorities to consider further steps toward new fiscal responsibility legislation that would replace and strengthen the Budget Enforcement Act. Moves in this direction would serve to catalyze and sustain political support for the needed fiscal adjustment by providing a suitable framework for disciplining policies, and placing tax and expenditure decisions in the appropriate medium-term context.
Directors urged the authorities to take early steps to strengthen the financial position of the Social Security and Medicare systems. Relatively modest changes, if taken in a timely fashion, could be sufficient to close projected shortfalls in the Social Security system. However, the financial position of the Medicare system is particularly difficult. In light of this, some Directors emphasized that any measures to enrich benefits should be placed in the context of a broad strategy to deal with the system's longer-term financial problems. A number of Directors also stressed the need to consider the difficult financial situation of the state and local budgets.
Directors welcomed the resilience of the U.S. banking system in the face of the economic slowdown, and noted that banks' balance sheets appear to have held up well. Vigilance will, nevertheless, be needed to ensure that banks are well-positioned to absorb the effects of an eventual turnaround in interest rates or a possible cooling of real estate markets. Although Directors noted that the government-sponsored enterprises do not appear to pose a systemic risk, they urged the authorities to continue to monitor closely their risk management and accounting practices, and to ensure that their disclosure was adequate. A number of Directors saw merit in steps that would further limit these agencies' special status. Some Directors reiterated their encouragement to the United States to undertake a Financial Sector Assessment Program. Directors welcomed the authorities' intensified efforts to combat money laundering and the financing of terrorism, and looked forward to early full compliance with Financial Action Task Force recommendations.
Directors welcomed the considerable progress that has been made toward strengthening the oversight of accounting and corporate governance during the past year. The priority now is to ensure that the responsible agencies are provided with sufficient resources and support to complete the reform agenda, in particular on improving accounting standards, ensuring the independence of corporate boards, and harmonizing U.S. and international accounting standards. Many Directors expressed concern about the significant underfunding of defined-benefit corporate pension plans that has emerged in recent years. They called for a strengthening of the accounting, transparency, and funding of these plans. In the latter case, some Directors particularly pointed to the merit of relaxing tax penalties against contributions to fully funded plans. Some Directors also underscored the importance of carefully reviewing options for strengthening the finances of the Pension Benefit Guaranty Corporation.
Directors called upon the United States to continue to play a leadership role in promoting an open multilateral trade system. They acknowledged that the U.S. authorities have already made useful proposals for moving the Doha Round forward, and looked forward to further concerted efforts to find common ground with partner countries. Going forward, it will also be important to continue to ensure that U.S. efforts to promote bilateral and regional free-trade agreements are complementary to the multilateral approach to liberalization, and designed in a manner that limits trade diversion and administrative complexities. Some Directors also encouraged the authorities to take early action to comply with recent World Trade Organization rulings.
Directors welcomed the U.S. authorities' commitment to boost development assistance, and looked forward to further increases from its still very low level in relation to GNP. Many Directors also saw scope for improving the complementarities between development and trade policies, including by reducing U.S. agricultural subsidies further and lowering non-tariff barriers to imports from developing countries.
IMF EXTERNAL RELATIONS DEPARTMENT