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United States and the IMF
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On July 22, 2005, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with the United States.1
The U.S. economy has continued to lead the global recovery over the last year. Output growth had been slowed by the effects of the bursting of the IT bubble and geopolitical developments following the 2001 terrorist attacks, but household spending has remained robust and business investment has rebounded, supported by low interest rates. Despite having eased somewhat as the expansion has matured, productivity growth has remained well above longer-term trends and supported record-high corporate profits.
The economy has proved resilient in the face of high energy prices. After expanding at a 4½ percent rate in 2004, real GDP growth eased to 3¾ percent in the first quarter of 2005. Some further softening may have taken place in the second quarter, but recent indicators suggest that activity will regain momentum in the second half. In particular, domestic demand remains solid, based on steady employment gains, a firming of business sentiment, investment, and improving consumer confidence.
As economic slack has narrowed, the inflation environment has become less benign. Although the core deflator for personal consumption expenditure-the Federal Reserve's preferred inflation indicator-has risen only modestly to just above 1½ percent (12-month rate), higher energy prices pushed headline CPI inflation to 2½ percent in recent months. The labor market has exhibited few signs of overheating-employment growth has been moderate by historical standards and the drop in the unemployment rate to 5 percent appears to have largely reflected lower participation. However, slower productivity growth since mid-2004 has contributed to an acceleration in unit labor costs.
The policy focus in the United States has appropriately shifted toward the removal of stimulus. Having cut the federal funds rate aggressively over the downturn, the Federal Reserve reversed course in mid-2004 as deflation risks receded, and has since raised the rate by a cumulative 2¼ percentage points. The Administration has reaffirmed its commitment to reducing the budget deficit to below 2 percent of GDP by FY2009 through rigorous spending restraint, and to making earlier tax cuts permanent.
The U.S. expansion and low interest rates have provided a substantial boost to the rest of the world at a time of significant global slack. U.S. net imports have increased growth in the rest of the world by about ¼ percentage point a year since 2001. U.S. financial conditions have also helped compress risk premiums, lowering interest spreads and supporting activity across a wide range of emerging markets.
The current account deficit has steadily widened, however, as U.S. growth has continued to outpace that of most trading partners. Despite the depreciation of the U.S. dollar by about 12 percent in real effective terms over the past three years, the current account deficit increased to a record 6½ percent of GDP in the first quarter of 2005. This has been mainly driven by sustained strong growth in real imports of consumption goods and higher oil prices.
Financial flows in the United States have also departed from long-term trends and appear unsustainable, with foreign savings and corporate profits increasingly financing government and household spending.
· The counterpart of the current account deficit has been massive foreign capital inflows, with U.S. net international liabilities estimated to have risen to over 20 percent of GDP.
· Net lending by the corporate sector is also at record highs. Notwithstanding difficulties with auto and airline sectors, businesses have used high profits to strengthen balance sheets that-along with foreign inflows-have contributed to low long-term interest rates.
· Tax cuts and expenditure increases have turned the public sector into a significant borrower. The federal government budget shifted from a 2½ percent of GDP surplus in FY 2000 to a 3½ percent of GDP deficit in FY2004, leaving the general government deficit at 4¼ percent of GDP in calendar year 2004. Reflecting buoyant revenue growth, however, both deficit measures are expected to continue to improve notably over the medium term.
· The household saving rate has fallen to record lows. Even accounting for the boost from strong asset markets, the IMF staff estimates that the saving rate is currently some 1½-2 percentage points below a level consistent with household income and wealth.
Barring shocks, the staff projects growth of 3½ percent in 2005 and 2006, slightly above potential and close to the consensus forecast. Reflecting some rebalancing of growth and normalizing domestic financial flows, both the personal and national saving rate would gradually rise while stronger investment would reduce corporate net lending. Although the trade balance would benefit somewhat from lagged exchange rate effects, the current account deficit would remain at over 6 percent of GDP (assuming an unchanged real exchange rate) as increasing foreign debt and higher interest rates would weigh on the income balance.
The financial sector appears well positioned to provide continued support to the recovery. Equity prices have risen, long-term interest rates remain low, banks are well capitalized and highly profitable, and indicators of credit quality remain strong. The robust housing market has caused financial regulators to tighten oversight of home equity and other residential loans. Notwithstanding strong house price increases in many regions, securitization of mortgage debt has limited systemic financial sector risks by allowing significant diversification of real estate exposures.
Executive Board Assessment
Executive Directors noted that, despite higher oil prices, the U.S. economy continues to lead the global expansion based on strong fundamentals. U.S. productivity growth has remained well above longer-term trends, supporting corporate profits, a rebound in business investment spending, and some acceleration in employment. Against this background, the policy focus in the United States has appropriately shifted toward the removal of policy stimulus.
Directors observed that, while subject to risks, the near-term outlook for the U.S. economy remains broadly favorable. A moderation in consumption growth as monetary conditions continue to tighten will likely be largely offset by rising investment and an improvement in real net exports. However, Directors cautioned that higher oil prices could begin to weigh more heavily on domestic demand. Many Directors also expressed concern about the rapid inflation of U.S. house prices in recent years, increased reliance of some households on less conventional mortgage products, and the already low personal saving rate. In addition, Directors noted that-with the U.S. external current account deficit expected to remain large well into the medium term-the staff's analysis suggests that the level of the U.S. dollar still remains above that necessary to avoid continuing increases in U.S. net external indebtedness. Against this background, Directors agreed that this underscores the importance of the cooperative strategy for addressing global imbalances.
Directors viewed the extremely low U.S. national saving rate as posing a key policy challenge going forward. In the context of the wide differences in growth across major regions of the world, this has contributed to a widening of global current account imbalances, which pose further associated systemic risks, especially if U.S. productivity growth were to falter. Most Directors accordingly stressed the importance of taking advantage of the present cyclical strength of the U.S. economy to set in train ambitious fiscal consolidation in coming years which, coupled with reforms to public retirement and health care systems, would help ensure their sustainability in the face of longer-term demographic pressures. Directors recognized that fiscal consolidation in the United States should be complemented by appropriate actions in other regions as part of a shared responsibility.
Against this background, Directors welcomed the commitment to fiscal deficit reduction in the FY2006 budget and the recent improvement in the budgetary outlook due to strong tax receipts. Nonetheless, most Directors considered the Administration's goal of halving the budget deficit to be relatively unambitious, as this would imply limited adjustment in the structural fiscal position in coming years. It is also subject to considerable risk, given the assumption of an unprecedented compression in nondefense discretionary spending.
Many Directors agreed that balancing the budget excluding Social Security by early in the next decade would support national saving, domestic investment, and the external position. This approach would significantly lower the federal debt ratio, providing the room to cope with impending pressures on entitlement programs and improve intergenerational equity.
Most Directors noted that existing fiscal plans already assume strict spending discipline, and accordingly it would be prudent to explore options for revenue enhancements to support deficit reduction. To avoid having to unwind recent cuts in tax rates, many Directors felt that consideration should be given to broadening the income tax base or to taxing consumption more directly in the form of a national consumption or energy tax. A few noted that a legislated budget rule would also help support fiscal discipline, and re-authorization of the Budget Enforcement Act (BEA) provisions-including pay-as-you-go provisions that cover revenue measures-would be appropriate. Many Directors called for a simplification of the tax system and welcomed the establishment of the Advisory Panel on Federal Tax Reform.
Directors recognized the need to address the severe underfunding of the Social Security and, especially, Medicare systems. While the 2003 Medicare Modernization Act contained a number of provisions that could help moderate price pressures, the new prescription drug benefit significantly increases Medicare's underfunding. Thus, with public health care spending projected to triple as a ratio to GDP in coming decades, further steps are urgently needed to improve the efficiency of the overall health care system.
Directors welcomed the Administration's recent commitment to placing the Social Security system on a sustainable basis and the proposed introduction of personal retirement accounts (PRAs). However, they noted that PRAs will not reduce the system's funding gap, and that it was important to introduce accompanying measures that would ensure the system's long-run solvency. In this regard, they welcomed the Administration's recent support for specific measures to reduce the system's unfunded liabilities, and called for early legislative action to eliminate the funding shortfall.
Directors commended the Federal Reserve's gradual and flexible approach to monetary tightening, which has been effective in supporting activity while preserving price stability. Interest rate hikes have been coupled with clear messages that more forceful action would be required if price pressures continued to intensify. Indeed, as monetary conditions still appear accommodative, a more aggressive pace of interest rate hikes could not be ruled out if price pressures increase.
Directors noted that the Federal Reserve is already among the most transparent central banks in the world. Drawing on experience in other countries, a few Directors suggested that a clearer definition of the Federal Reserve's inflation objective could help further anchor inflation expectations and long-term bond yields, without unduly constraining the ability of policymakers to meet shorter-term stabilization objectives. Most Directors agreed, however, that with the Federal Reserve's impressive track record of maintaining low inflation and effective communication on policy intentions with financial markets, the additional gain from establishing a more explicit inflation objective would be relatively modest.
Directors recognized the importance of structural reforms to support saving, capital accumulation, and high labor productivity growth. These could include aligning the tax burden on saving and consumption, and promoting retirement plans in which participation is the default option.
Directors welcomed the Administration's recent emphasis on strengthening pension funding and improving supervision and shrinking the balance sheets of the housing government-sponsored enterprises (GSEs). At the same time, a few Directors noted that recent irregularities in the insurance sector suggest that there may be a need for supervision of systemically important entities at a national level. Finally, Directors welcomed the recent regulatory moves to tighten lending standards on mortgage instruments.
Directors welcomed Administration proposals for deep cuts in agricultural and non-agricultural tariffs as part of the Doha Round negotiations, as well as efforts to offer and elicit stronger commitments for liberalization in services. At the same time, many cautioned that care should be taken to ensure that the U.S. strategy of negotiating a large number of bilateral free trade agreements is consistent with the multilateral trading system. Directors emphasized that the recent protectionist pressures-including in the wake of the expiration of textiles quotas-are in the interest of neither the United States nor the rest of the world, and should be resisted vigorously.
Directors praised the recent increases in U.S. official development assistance (ODA), and the progress on the Millennium Challenge Account. They noted that U.S. ODA levels as a proportion of Gross National Income (GNI) remain one of the lowest among industrial countries and encouraged the authorities to further increase flows of such assistance.
1 Under Article IV of the IMF's Articles of Agreement, the IMF holds bilateral discussions with members, usually every year. A staff team visits the country, collects economic and financial information, and discusses with officials the country's economic developments and policies. On return to headquarters, the staff prepares a report, which forms the basis for discussion by the Executive Board. At the conclusion of the discussion, the Managing Director, as Chairman of the Board, summarizes the views of Executive Directors, and this summary is transmitted to the country's authorities.
IMF EXTERNAL RELATIONS DEPARTMENT