Tepid U.S. Recovery Poses Challenge for Policy Balance
IMF Survey online
June 29, 2011
- Economy recovering at modest pace, but has hit soft patch
- U.S. needs to address debt ceiling, launch deficit reduction plan
- Key challenge is to exit from stimulus policies without hurting recovery
The U.S. economy continues to recover at a modest pace, but has hit a soft patch. Concerns about risks, including the lack of a credible deficit reduction plan, persist, the IMF said after wrapping up its annual review of the world’s largest economy.
An IMF team, led by IMF Acting Managing Director John Lipsky, met with Treasury Secretary Timothy Geithner, Federal Reserve Chairman Ben Bernanke, senior government officials, and representatives from the private sector during May 27–June 27.
A final report will be issued once it has been discussed by the IMF’s 24-member Executive Board in late July.
“The U.S. economic expansion remains only moderate. At the same time, there are significant challenges ahead that will need to be dealt with decisively if the expansion is to strengthen,” said Lipsky at a press conference on June 29.
“The expansion could outpace our forecast if consumer confidence improves faster than we expect, but, on the downside, still-weak fundamentals pose risks to the housing markets. Moreover, a loss of fiscal credibility could cause an increase in interest rates or a sovereign downgrade, with significant global repercussions,” he added.
“At the opposite extreme, an excessively front-loaded adjustment could hurt the recovery. And a worsening of financial turmoil in European sovereign and bank debt markets could hurt U.S. growth through financial sector linkages,” Lipsky noted.
The debate over the debt ceiling has not yet been resolved. A failure to raise the debt ceiling would lead to a severe shock to the global economy, the IMF statement said.
On balance, the IMF expects U.S. growth to remain relatively modest, as private demand recovers only slowly and fiscal policy support is withdrawn. The institution projects growth of 2½ percent in 2011 and 2¾ in 2012, with a slow decline in unemployment.
Tackling the fiscal deficit
According to the IMF, the main policy challenge is to reach a political agreement on a fully-specified fiscal consolidation plan to ensure that the public debt-to-GDP ratio stabilizes by mid-decade and gradually falls afterwards. The adjustment should start in fiscal year 2012, but without putting an undue toll on the ongoing recovery.
“A well-defined medium-term plan based on realistic macroeconomic assumptions will allow a smooth adjustment path attuned to the current cyclical position, while containing market fears about unsustainable debt dynamics,” Lipsky said. Meanwhile, the proposed institutional enhancements such as a failsafe mechanism for the debt ratio could, if robustly formulated, play a useful role in supporting fiscal consolidation efforts, the IMF said.
However, much more needs to be done to address the medium-term fiscal imbalances. The IMF said that the specific fiscal consolidation measures presented by the administration so far do not stabilize the debt ratio under the IMF’s less optimistic growth and interest rate projections.
The overall fiscal effort will require both new revenues and cuts in mandatory spending programs which are the key drivers of long-term deficits. Options include the Social Security reform, savings in Medicare and Medicaid, reducing tax expenditures, and possibly introducing a national value-added tax and carbon taxes, the IMF said.
Nurturing the recovery
The IMF stressed that housing difficulties merit more policy attention since they are central to the slow recovery and pose a critical risk.
The policy design is complicated by operational capacity constraints and the risk of moral hazard. That said, the IMF noted that “Allowing court-determined changes in residential mortgages and adjusting federal mortgage modification programs to enhance participation could limit the supply of foreclosed houses in the market, therefore supporting house prices.”
At the same time, persistently high unemployment and underemployment call for a re-examination of existing job-training programs. The education system could play a stronger role in retraining the unemployed. Further tax cuts attached to programs aimed at spurring hiring of long-term unemployed workers could also help.
Restoring financial resilience
The U.S. financial system continues to heal, but remains vulnerable. Bank capital has increased, but underlying profits are weak, and mortgage markets remain largely government dependent. Among the risks, heightened turmoil in European financial markets or the tail risk of a U.S. sovereign rating downgrade could impact U.S. financial institutions and markets.
Therefore, implementing the reform of financial regulation and supervision decisively is another priority. The legislation passed in Congress last year was an important step forward, with nearly all of the recommendations under the IMF’s Financial Sector Assessment Program being addressed.
“Continued strong implementation of all these steps will be important and will require appropriate funding to regulatory agencies,” Lipsky said.
“Strengthening the incentives for sound credit underwriting and clarity on market rules, including the role for government-sponsored enterprises in housing finance, would lay the grounds for sustainable private sector securitization—a critical source of financing for future economic growth,” he added.
It will also be important to coordinate reforms internationally to promote a level playing field, the IMF said.
Monetary stimulus to remain for now
“The U.S. Federal Reserve has deftly managed the tradeoff between near-term support and medium-term credibility,” Lipsky said.
“It has maintained an extraordinary low level of policy rates, expanded its balance sheet, and signaled its intention to keep an accommodative stance for an extended period. Such a position, which will likely remain appropriate for quite some time, will serve to counteract the forthcoming fiscal drag on economic activity. The Fed should remain vigilant to the risk of any potential unmooring of long-term inflation expectations and respond decisively should the risk materialize in either direction,” he added.
When suitable, a gradual unwinding of the Fed’s balance sheet by ceasing the reinvestment of maturing securities seems to be a reasonable first step in normalizing monetary conditions, the IMF said. Short-term interest rates would serve as the main active tool to fine tune the adjustment of monetary conditions.
Consistent with the G-20 Mutual Assessment Process, they key contributions that the U.S. can make to global growth and stability are: (i) raising domestic savings, particularly through fiscal consolidation, to help ensure that the current account deficit remains contained and to forestall potentially destabilizing increases in public debt; and (ii) strengthening its financial sector through enhanced regulation and supervision. The U.S. dollar depreciation over the past year would also contribute to global rebalancing, the IMF said.
The IMF is also undertaking spillover analysis of the five largest economies in the world—China, the euro area, Japan, the United Kingdom, and the United States—as part of its annual Article IV discussions with these countries. The U.S. spillover report will be published alongside the U.S. Article IV report in late July.
The analysis confirmed that the effects of U.S. policies on the rest of the world economy are uniquely large, mainly reflecting the pivotal role of U.S. markets in global asset price discovery.
Looking forward, a normalization of the monetary policy stance in the United States is likely to reverse some capital flows to emerging markets with open capital accounts by reducing interest rate differentials. This puts a premium on clear communication by the Fed regarding its future policy moves, the IMF said.
Furthermore, a credible and gradual U.S. fiscal consolidation would likely have limited negative short-term spillovers and substantial long-term benefits for the rest of the world. The costs associated with the tail risk of a loss of confidence in U.S. debt sustainability would be very large.
Finally, robust prudential supervision of U.S.-based (not necessarily U.S.-owned) investment banking activities can reduce risks that problems in dollar wholesale funding markets would precipitate another global banking shock, the IMF statement concluded.