IMF Executive Board Concludes 2007 Article IV Consultation with the United StatesPublic Information Notice (PIN) No. 07/92
August 1, 2007
Public Information Notices (PINs) form part of the IMF's efforts to promote transparency of the IMF's views and analysis of economic developments and policies. With the consent of the country (or countries) concerned, PINs are issued after Executive Board discussions of Article IV consultations with member countries, of its surveillance of developments at the regional level, of post-program monitoring, and of ex post assessments of member countries with longer-term program engagements. PINs are also issued after Executive Board discussions of general policy matters, unless otherwise decided by the Executive Board in a particular case. The staff report (use the free Adobe Acrobat Reader to view this pdf file) for the 2007 Article IV Consultation with the United States is also available.
On July 27, 2007, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with the United States.1
The U.S. economy has cooled more than expected over the past year, but employment remains strong and growth abroad has picked up. Following an extended boom led by strong domestic demand, the slowdown has largely reflected a drag from residential investment as the housing market has weakened substantially. Unexpected weakness in business investment and net exports, as well as an inventory correction, amplified the downturn in early 2007, but growth is expected to recover in the remainder of the year. Private consumption has continued to grow robustly as solid employment and wage growth have minimized spillovers from housing, unemployment has remained extremely low, and, as a result, core inflation has only recently started to ease. The global environment remains favorable, with robust growth in the euro area and Asia.
The most likely scenario is a soft landing of the U.S. economy, with growth picking up during 2007 as the housing drag dissipates, business investment recovers, and net exports rebound on strong foreign demand. Core inflation should ease as the output gap widens.
At the same time, there are important risks to this outlook. Growth is uncomfortably close to the "stall speed" associated with past recessions, even though unemployment and real interest rates are more favorable. Subprime mortgage difficulties could extend the housing downturn, which in turn could weaken consumption, and financial conditions could tighten. And with output close to potential, unemployment low, commodities prices elevated, and productivity growth falling, cost pressures could boost inflation.
Financial innovation and stability have been critical to U.S. economic success. Innovation has been instrumental in attracting capital inflows and easy financing of the current account deficit, and has also helped disperse risk, as core institutions have moved to an "originate-to-distribute" model and derivative markets have grown. At the same time, new instruments have made it more difficult to assess vulnerabilities and have thus created new regulatory challenges.
The current account deficit stabilized at 6 percent of GDP in 2006, with a stronger nonoil trade balance partly offset by the impact of higher oil prices and lower net investment income. At unchanged real exchange rates, the current account deficit is expected to narrow only slightly, implying an accumulation of U.S. net foreign liabilities. Staff analysis suggests that further dollar depreciation would be required over time to realign with fundamentals.
Short-run fiscal developments have been highly favorable, with the Administration's goal of halving the deficit by FY 2009 achieved three years ahead of time, largely on the strength of surging revenues. The Administration and Congress have both endorsed a target of balancing the budget by FY 2012, but agreement on how to achieve this objective, while providing appropriately for war costs and for Alternative Minimum Tax relief, has yet to be reached. Looking further ahead, the key challenge will be entitlement reform; without it, federal spending on Social Security, Medicare, and Medicaid is set to increase sharply over coming years, threatening long-run fiscal sustainability.
Executive Board Assessment
Executive Directors agreed with the thrust of the staff appraisal. Prospects for the U.S. economy are favorable, as activity has cooled following an extended boom led by domestic demand. Nonetheless spillovers from the housing market slowdown and the subprime mortgage market problems cannot be overlooked. Thus, the most likely scenario is a soft landing, with growth recovering and inflation easing, but risks remain. In particular, consumption could be weaker and financial market conditions could tighten rapidly. Directors also cautioned that cost pressures from rising oil and commodity prices and a tight labor market could raise inflation risks.
Against these prospects, Directors considered current monetary policy to be consistent with a soft landing. They commended the Federal Reserve for its emphasis on well-anchored inflation expectations, and saw scope for flexibility in balancing inflation risks with concerns about activity.
Financial innovation and stability have been key to U.S. economic success and the funding of the current account deficit. The financial system has shown impressive resilience, including to recent difficulties in the subprime mortgage market, but new regulatory challenges have been created by rapid innovation. Directors agreed that regulators should focus prudential oversight on core commercial and investment banks and welcomed the authorities' plan to review options for streamlining the financial regulatory system. They cautioned, however, that financial innovation has complicated risk assessment at a time of higher risk taking and deteriorating lending standards in some sectors. As financial conditions tighten, unanticipated risk concentrations and links across markets could come to light. This underlines the importance of ensuring that risk management systems are robust. Recent problems with subprime mortgages also highlight the need for consistent consumer protection, without undue constraints on innovation.
The new emphasis on improving the effectiveness of financial regulation is welcome. To ease interagency coordination and shorten regulatory reaction times, Directors supported increased use of general principles as a guide to rule making and recent initiatives to explore the scope for rationalizing the regulatory structure.
Directors also welcomed initiatives to lower regulatory costs and increase financial market competitiveness. These include guidance reducing the compliance burden of parts of the Sarbanes-Oxley Act on smaller firms, new rules making deregistering from U.S. exchanges easier for foreign companies, and the consideration given to recognizing some foreign regulatory regimes and international accounting standards.
Directors agreed that large valuation gains have stabilized U.S. net foreign liabilities as a ratio to GDP in recent years, but the upward trend is likely to resume given large current account deficits. They noted the staff's assessment that the dollar appears to be overvalued relative to its longer-term value in real effective terms and that a further real depreciation could contribute to rebalancing demand and asset portfolios — although, with rapid financial innovation continuing to attract net capital inflows, the adjustment would likely be gradual. A number of Directors, however, found that the evidence for the overvaluation of the dollar was not convincing.
While a disorderly resolution of global imbalances is unlikely, the potential costs are high as a disruption in U.S. financial markets would lower both domestic and — via financial market spillovers — foreign demand. Directors thus emphasized the importance of sound and innovative U.S. financial markets and implementation of policies to support U.S. saving agreed in the Fund's Multilateral Consultation.
Directors recognized the authorities' commitment to free trade and urged them to adopt a more ambitious agenda to achieve a positive outcome to the Doha Round.
Directors commended recent fiscal performance and the intention to balance the budget by FY 2012. They emphasized, however, that further effort would be needed to forge consensus on how to achieve budgetary balance.
The key fiscal challenge remains reform of unsustainable entitlement programs. Directors welcomed proposals to contain the budgetary costs of Medicare spending by strengthening the link between premiums and income, while cautioning that sustainability would require more fundamental reform of the high-cost health system. They also urged the authorities to develop a consensus on Social Security reform.
A tighter medium-term target would offer greater room for maneuver in addressing long-term fiscal pressures, while also contributing to current account adjustment. A number of Directors supported a target of balancing the budget excluding the Social Security surplus. It was also observed that revenue increases might be needed to achieve this goal, and a number of Directors viewed that higher taxation of energy consumption should be considered. They also emphasized the need to overhaul the complex tax system by reducing and better targeting write-offs while further shielding saving from income taxes.
It is expected that the next Article IV consultation with the United States will be held on the standard 12-month cycle.