Transcript

Washington, D.C.
Thursday, August 2, 2012

MS. BECKMAN: Thanks for calling into the conference call on the U.S. Article IV staff report, PIN, and selected issues papers. Today we are hearing from Gian Maria Milesi-Ferretti, who is the Mission Chief to the U.S., and from Roberto Cardarelli, who is the North America Division Chief in the Western Hemisphere Department.

Gian Maria is going to make some brief opening remarks, and then from there we can open up for questions.

MR. MILESI-FERRETTI: Good morning and thanks for calling in. Just a few words on our report. We focus on the outlook for the economy as well as policy stance and policy options. On the outlook we see the recovery as continuing to be tepid in pace with only a gradual reduction in unemployment. We see the headwinds from the recovery as coming primarily from a still weak housing market. Although it is firming up, it is still way below its normal levels and the very large effect of declining house prices on household balance sheets is still providing a brake to stronger recovery in consumption. Also we have a fiscal policy that has turned contractionary. The government is reducing spending and that also entails some drag for the economy.

Looking forward we see the main risks coming from both external and domestic sources. From external sources there are potential spillovers of further financial turmoil in the euro area and the impact that this turmoil may have on real activity in the euro area and elsewhere as well as on financial markets.

From a domestic perspective, we see risks coming from two domestic fiscal sources; that is, the possibility of a materialization of a very large adjustment in the fiscal balance for next year, the so-called “fiscal cliff,” a very sharp increase in taxes and reductions in discretionary spending at the beginning of 2013, which in our view would take a very heavy toll on the economy and ought to be avoided.

At the same time, once again there is a need to raise the debt ceiling either very late this year or early next year, and it is imperative to do that in advance so as to minimize the potential for financial market disruptions. You may all recall what happened in the summer of last year after this protracted and acrimonious debate on raising the debt ceiling, you had a plunge in business and consumer confidence. And this is really something that can easily be avoided and needs to be avoided.

And finally I will say monetary policy has been very supportive of the recovery with its extraordinarily accommodative stance. And, of course, should the outlook remain weak or deteriorate further, there is clearly some further scope for action as indeed the Federal Reserve Board has signaled yesterday in the FOMC statement.

MS. BECKMAN: All right. And with that, we can start to take questions.

SPEAKER: Yes, I have a question about the ramifications of the debt rating downgrade for the U.S. last year. We saw a safe haven reaction in U.S. Treasury yields. I’m curious, what do you think a further rating downgrade would do? Do you think it would lead to the same reaction in borrowing costs? And beyond that, what do you think of the longer term ramifications of seeing a debt downgrade like this?

MR. MILESI-FERRETTI: It is a very good question. Clearly what happened last year was to some extent counterintuitive; that you had in the end a decline in bond yields following the downgrade. I wouldn’t take this as a stylized fact of what is likely to happen should there be a further downgrade. So I think obviously in order to assess implications on interest rates, I’d like to know what is the international environment. The episode last year happened during a period of financial turmoil in the euro area. In terms of alternatives for flows seeking safe-haven destinations, the more complicated situation in the euro area encouraged flows towards the United States.

Rather than just a rating downgrade per se, I would also take a look at what are the factors triggering it. It is clear that in the current environment, there is a lot of demand for safe assets, and a lot of assets that were considered safe before are not considered safe anymore and this tends to boost demand for Treasuries.

But we think that should the U.S. fiscal outlook continue to remain very unfavorable with no action taken on addressing medium-term fiscal problems, sooner or later there will be a response in bond markets. And we clearly don’t see this as something that is likely to happen over the short term, particularly because of the very unsettled situation elsewhere and also because of weak growth prospects and extreme risk aversion. But, of course, this is not a danger that one ought to overlook looking forward.

SPEAKER: Yes, hi. I was wondering, since you’ve done this assessment a few months ago, was wondering whether you think that the eurozone -- the effects of the eurozone and the spread of the contagion into Spain and Italy and elsewhere and you’ve seen downgrades in Germany -- whether you think that that has now intensified in the U.S.? We’ve seen the U.S. authorities getting a lot more worried. So where are you seeing that? Are there any new signs on it?

My second question is if conditions do worsen, how soon would you expect the States to act and in what way?

MR. MILESI-FERRETTI: Let me start with the turmoil in the euro area and the channels of transmission to the U.S. economy. So the most obvious one, of course, is that if you have a slowdown in activity in the euro area, you are going to have lower demand for U.S. exports. Now U.S. exports to the euro area are in the range of 15 or 20 percent of total U.S. exports and about 2 percent of U.S. GDP. So it’s not an enormous number, but still it is something that is going to have a material effect on U.S. exporters.

There are also additional effects that come from the fact that turmoil in the euro area tends to generate safe haven flows to the United States, and this tends to appreciate the dollar. And dollar appreciation has a pretty strong negative effect on U.S. exports everywhere, not just to the euro area. So that is also a headwind to U.S. growth.

And then you have financial transmission channels, and those are complex. On the one hand, as I mentioned, you have safe haven flows to the U.S., so typically interest rates on safe assets in the United States like U.S. Treasuries tend to go down during this period, which is good if you want expansion for the United States. But at the same time, you have a widening of interest rate spreads, so interest rates on risky assets then tend to rise. And turmoil can also complicate life for U.S. financial institutions. You may have the CDS spreads on U.S. banks widening because, of course, U.S. banks are strongly connected to major financial institutions in the core of the euro area.

And then you can have additional effects coming also from the stock market, not just from increasing risk aversion, but also from the fact that U.S. multinationals have actually a lot of sales in Europe. Those are not just U.S. exports, they’re literally the affiliates of U.S. multinationals that have their production facilities in Europe. And the value of those, the profits generated by this overseas component of U.S. multinationals, is sizeable and those would also be affected. So you have a range of channels that are operative, and recently you’ve seen clearly a slowdown in U.S. exports to the euro area. You’ve seen a dollar appreciation and a bit of a loss in momentum in U.S. exports during the past few months.

SPEAKER: I was wondering because considering what the Fed did yesterday, if you could comment on that. And number two, you’re saying that if conditions worsen that the fed should then act. At what stage would you see the Fed acting? And what would it exactly do?

MR. MILESI-FERRETTI: Well, the Fed has a dual mandate both on the inflation front and the unemployment front, and if you have inflation below target and unemployment clearly above target and no sign that unemployment is moving at a decent pace in the right direction, there is clearly scope for action.

Now, we were arguing that deterioration in the outlook would be a trigger for additional policy measures. We have seen a slowdown in the second quarter, and there is clearly an issue as to whether this is a temporary blip and we will return to a growth rate in the low 2’s, or whether this is a sign of a more protracted slowdown. We think in the latter case there is clearly more scope for additional action, and the Federal Reserve has indicated a number of potential ways in which they could act. One of them is further purchases of securities, in particular we think that they could purchase mortgage-backed securities, given the effect that those purchases could have on mortgage rates by driving down MBS rates, could drive down mortgage rates to some extent. But you can also have through additional purchases of securities an effect on other interest rates as well as the stock market. As you remove safe assets from the market, you have a shift in the market on its riskier assets, and then can help not just lower mortgage rates, but also provide some boost to riskier investment including the stock market.

Other options include “forward guidance” as it’s called, an explicit statement by the Fed that the horizon over which it plans to maintain extraordinary low interest rates will stretch beyond the end of 2014, which is the current deadline if you want that they’ve set for themselves. And you can also think of reductions in interest rates on excess reserves. So there are a number of tools that could be deployed. These are clearly not very flexible tools -- they’re a bit clumsy if you want. It is not an easy action, such as a reduction in interest rates during a slowdown. And this is clearly one of the reasons why they are deployed with utmost care. There is also less experience on what the implications would be, but clearly a worsening of the outlook would warrant taking action in that direction.

SPEAKER: Hi, yes. I was just wondering on the housing front where you do talk about some firming. I mean is it actually going to be adding to growth next year or is it just like it’s not that significant, but it’s slightly going up? Can you just comment a little bit on the housing?

MR. CARDARELLI: Yes, well we’re actually seeing -- the few positive signs that we’ve been seeing recently actually are coming from housing. We have seen house prices sort of picking up somewhat on a national level, construction also sort of picking up. And the reason essentially is that we have gone to a point where we’re sort of -- the market -- it’s normal to see some stabilization. I mean house prices we still believe they’re below what they should be. There’ve been some measures taken recently by the authorities, that are, indeed, having some effect. So we’re seeing some signs. In terms of construction, household formation, which is the demand-side of housing, is slowly sort of picking up. Consider that housing starts are running at about half what they should be. I mean this 700,000 housing starts is about half what we believe is sort of an equilibrium-kind of growth rate. . We actually have a projection that it’s going to go back, the housing construction, is going to go back to that level in four or five years, which is a long time, but the direction is clearly upward.

And as I said, right now it’s one of the few bright spots in terms of the outlook. So it’s going to add to growth over the few next years.

SPEAKER: Hi there. I wonder if you could talk some more about the fiscal cliff and the impact that’s likely to have on the U.S. economy if nothing is done?

MR. MILESI-FERRETTI: Sure. So the fiscal cliff is this very significant expiration of tax measures, of tax reductions, that would entail increasing taxation early next year by something in the order of 3 percent of GDP or more, as well as drastic cuts to discretionary spending generated by the so-called sequester. This was supposed to be an incentive for policymakers to agree on more reasonable cuts by having a threat of something really bad happening. And because policymakers did not agree, you now have that something really bad could happen early next year.

So let’s start from some of the implications that the cliff could have before it materializes. So clearly it can have effects, materializing in the second half of this year, and even more in the last quarter, if there is a sense that this drastic fiscal adjustment could actually materialize because no agreement can be reached across the political spectrum. What could that entail? Well, you can think of a number of contracts with, say, for defense, which is one of the sectors that is going to be affected by the cuts, which would not go through. You have public agencies that are curtailing spending already in anticipation of these potential shortfalls early next year. You can have consumption and investment held back by uncertainty about what’s going to happen to taxation early next year.

Then you have the risk of the actual materialization of the cliff. If nothing were done for the whole year, you would have over 4 percent of GDP in fiscal adjustment. This is literally unprecedented in terms of size, and it would occur at the moment when the U.S. economy is weak and where other tools to cushion the impact of that adjustment -- typically monetary policy -- are less effective because you don’t have much scope to cut interest rates. So what we would see in terms of projections -- and not just us, but even other very reputable institutions that have done work in this area, including the Congressional Budget Office, would see GDP growth turn negative early next year. And just out of the impact of the cliff, you would see a year with a potential recession or no growth at all.

Of course, what the potential ramifications could be we don’t know, but they could be quite negative. If you have a big loss of confidence reflected in stock market declines, you’d have negative spillovers immediately to trading partners like Canada and Mexico, but also beyond that, given the size of the U.S. economy. If you go from -- we project growth rate of about 2.25 next year -- if you go from 2.25 to zero or negative, you are inflicting a very sizeable shock to the world economy. So you can think of all kinds of possible additional ramifications. So in short, it’s certainly not a good outcome. It is a very bad outcome for the U.S. economy. It is a bad outcome for the world. And it can be avoided, and it should be avoided.

MS. BECKMAN: Were there any points that you wanted to make that you didn’t make during the call?

MR. MILESI-FEFFETTI: Maybe just -- I’ll just elaborate a bit on why do we eventually see an acceleration in growth in the U.S. economy. Some questions have surfaced as to ‘are we now stuck in a sense in this low growth, high unemployment environment? And what is it that could eventually pull the U.S. economy out?’ And as my colleague, Roberto, was saying, we think that one key factor in pulling the U.S. economy towards higher levels of employment and growth is eventually going to be the recovery of the housing market.

So the housing market has not moved offshore. It has suffered a very bad shock because of the bursting of the housing bubble. And as a result of the lingering consequences of that shock, we see a glut of houses particularly in the single-family segment. And at the same time, we have seen for a protracted period of time really sub-par construction. But we know that over the next few years, the formation of U.S. households and the depreciation of the housing stock will imply that there will be a need for about 1.5 million homes to be built on a yearly basis. This may not happen right away, of course, but it is likely to happen over a period of three, four, five years. And given that the pace of construction activity at the moment is barely above 700,000, you see that there is quite a bit of scope for a strong pickup in construction. Again, it’s going to be gradual because you need to absorb the existing inventory of properties that have been foreclosed or that have been withdrawn from the market and may return on the market, but that is clearly going to be something that is going to help U.S. growth over the medium term. And, of course, a firming of the housing market has all sorts of other positive implications for household balance sheets, for confidence, and for demand in other sectors that are connected to construction and housing. So that’s perhaps the one thing I wanted to highlight.

SPEAKER: Sure, thanks a lot. Thanks for taking these questions. It has to do, I guess, with financial regulations. Some banks are saying that there’s over-regulation and that’s one reason that they’re not lending, and I really don’t know what to make of it. I wonder when you look at the housing market, if you see any impact of the Consumer Financial Protection Bureau or the Community Reinvestment Act. And also if you have any suggestions for financial regulation in the U.S. that could actually help the issues that you’re describing?

MR. MILESI-FERRETTI: So we know that credit conditions for households are tight, and that you have on the one hand the positive impact of extremely low mortgage rates, but on the other hand you have now the average credit score of people that get a mortgage that is extremely high. So the conditions are really easy only for households that have particularly high credit scores.

Now why is that? Well, clearly you have a number of factors, and some analysts, and financial institutions as well, have argued that uncertainty about the regulation of mortgage market, including rules on risk retention and the qualified residential mortgage -- there’s a variety of rules in this area that have yet to be finalized-- somehow are providing headwinds to looser conditions in mortgage markets. We think that clearly it would be good for the market to have an early resolution of uncertainty. We just don’t think that is the main reason why you see these headwinds. You had clearly declining competition in mortgage markets that resulted from the fact that many financial institutions that were operating in this area either consolidated, others went bust. You also have sort of the legacy of the crisis. So you have outstanding difficulties in handling a very high volume of foreclosures, for example, and delinquent loans that clearly institutions and services were not ready to absorb. And you have had cuts in staffing in these areas in banks because of the downturn in the housing market more generally. And this clearly hampers a speedier recovery when demand increases, and you have households that have held back on their own.

So we think there is a complex set of factors -- high unemployment, the weak economy as a whole -- and we think that you clearly needed tighter financial regulation in the U.S. We don’t think it is the only answer. We think you need proactive and very carefully coordinated supervision of financial institutions as well, but it is essential to set the rules in place. We’ve said that explicitly in the report. And where the rules have not been finalized, a speedier conclusion of the process would be helpful in terms of easing uncertainty.

MS. BECKMAN: With that we’ll conclude the conference call on the U.S. Article IV. Just a reminder that the contents of the call and the staff report are embargoed until 10:00 a.m. Eastern. Thanks for calling in.