## _cr06279 — Executive Summary and Selected Chapters ## Source details **Canonical URL:** [_cr06279 — Executive Summary and Selected Chapters](https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2006/_cr06279.pdf) ## Other formats - [Markdown version](/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2006/_cr06279.pdf.md) - [Structured JSON version](/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2006/_cr06279.pdf.json) --- ### Executive summary: macro outlook, policy priorities, and institutional recommendations - Macro performance and outlook: - Real GDP (percent change from previous period): 2005 3.5; 2006 3.5; 2007 3.1; 2008 3.2; 2009 3.2; 2010 3.2; 2011 3.2. - CPI inflation: 2005 3.4; 2006 3.2; 2007 2.6; 2008 2.5; 2009 2.5; 2010 2.5; 2011 2.5. - Unemployment rate (percent): 2005 5.1; 2006 4.8; 2007 4.8; 2008 4.8; 2009 4.8; 2010 4.8; 2011 4.8. - Unified federal balance (Fiscal year, percent of GDP): 2005 -2.6; 2006 -2.3; 2007 -2.6; 2008 -2.3; 2009 -2.0; 2010 -1.9; 2011 -1.8. - Current account balance (percent of GDP): 2005 -6.3; 2006 -6.5; 2007 -6.7; 2008 -6.7; 2009 -6.7; 2010 -6.7; 2011 -6.7. - Oil prices ($/Barrel, Average petroleum spot price): 2005 53.4; 2006 66.5; 2007 69.8; 2008 68.5; 2009 67.5; 2010 66.8; 2011 66.0. - Key risks and policy trade-offs: - Downside growth risks: abrupt housing slowdown, productivity disappointments, disorderly external adjustment, avian flu, geopolitical events. - Upside inflation risks: pickup in core inflation, pass-through of high commodity prices, potential productivity slowdown. - Policy priority: Federal Reserve must balance downside activity risks with upside inflation risks; staff and Directors suggested the Fed provide a more explicit statement of its inflation objective and consider more forward-looking Monetary Policy Reports. - Financial-sector and institutional recommendations: - Tighten supervision of the housing GSEs. - Move toward consolidating supervision and regulation of insurance companies. - Reform corporate pension plans and improve PBGC funding and pension accounting transparency. - Publish a regular Financial Stability Report and undertake an IMF FSAP for the United States. *Source: Executive Summary, _cr06279* ### I. Outlook, demand composition, and housing risks - Demand components and forecasts: - Total domestic demand (percent change): 2005 3.6; 2006 3.7; 2007 3.1; 2008 3.1; 2009 3.1; 2010 3.1; 2011 3.1. - Private final consumption: 2005 3.5; 2006 3.1; 2007 2.8; 2008 2.8; 2009 2.8; 2010 2.9; 2011 2.9. - Net exports (contribution to growth, NIPA basis): 2005 -0.3; 2006 -0.4; 2007 -0.2; 2008 -0.1; 2009 -0.1; 2010 -0.1; 2011 -0.1. - Housing and household finance: - Home equity withdrawal (HEW) rose to a record 8 percent of U.S. personal income in 2005. - Staff observed house prices appeared overvalued; Chapter 1 suggests house prices are 15–20 percent above equilibrium. - Baseline: real house price inflation likely to halve to 5 percent in 2006 (yoy) and decelerate further subsequently. - Estimated impact: combined reduction in consumption and residential investment implied a reduction in GDP growth of around ½ percent of GDP over the next two years (Annex I). - HEW and saving: - Cross-country evidence: about 15–25 percent of withdrawn equity used to finance consumption; remainder largely for acquisition of financial assets and debt repayment. - Regression evidence: changes in HEW lead to a 15–20 cents in the dollar temporary offset on U.S. household saving (short-run effect); long-run HEW does not affect household saving rates. ### II. Monetary policy: stance and transmission - Policy rates and assessment: - At discussions staff suggested the federal funds rate at 5 percent was close to most estimates of neutral. - FOMC subsequently raised the federal funds rate to 5¼ percent on June 29. - Market expectations and staff “risk management” analysis implied scope for a further 25 basis points increase contingent on incoming data. - Transmission and global integration: - Officials highlighted uncertainty about low long-term bond yields: low term premiums could reflect portfolio preference shifts or weaker global investment demand/high saving. - Increased global financial integration may have muted long-term rate responses and monetary transmission. - Labor market and inflation signals: - Unemployment at 4¾ percent in April (noted as low end of NAIRU estimates); capacity utilization around long-run average. - Unit labor cost increases contained due to solid productivity growth; wage pressures expected to pick up but strong productivity and margin flexibility could limit pass-through to inflation. - Commodity price boom posed short-term inflation risk; energy prices feeding into inflation expectations. ### III. Financial stability, market structure, and regulatory priorities - Financial-sector resilience: - Distance-to-default and VaR measures for LCBGs, the “big five” investment banks, and insurance sector recovered to mid-1990s levels; capital adequacy remained strong. - Banks sustained profitability via non-interest income despite margin pressures. - Emerging vulnerabilities and recommended policy actions: - Monitor increased risk-taking: rising loan leverage ratios, pickup in leveraged buyouts, growing nonbank activity (hedge funds). - Regulatory recommendations: - Limit GSE portfolios and strengthen supervision; consider new regulator, risk-based capital, portfolio limits. - Address fragmented insurance supervision; consider stronger federal role. - Tighten guidance for home equity and nontraditional mortgages; focus on counterparty risk from hedge funds rather than direct hedge fund regulation. - Limit ILC expansion in national branch networks and address consolidated supervision gaps. - Suggested Fund actions: undertake a U.S. FSAP and consider publishing a Financial Stability Report. ### IV. Fiscal policy, entitlements, and sustainability - Short- and medium-term fiscal developments: - FY 2006 unified federal deficit (Mid-Session Review): $296 billion (2¼ percent of GDP) versus prior February estimate $423 billion (3¼ percent of GDP). - Staff-adjusted unified balance (percent of GDP): 2005 -2.6; 2006 -2.3; 2007 -2.6; 2008 -2.3; 2009 -2.0; 2010 -1.9; 2011 -1.8. - Staff recommended establishing a more ambitious medium-term fiscal anchor: balance the budget, excluding the Social Security surplus, within the next five years — consolidation of around ¾ percentage point of GDP a year. - Long-term entitlement pressures and numeric indicators: - Trustees estimate: the 75-year funding gap of the Social Security and Medicare systems at 325 percent of GDP. - Social Security currently running a cash surplus of 1½ percent of GDP but projected to fall into deficit as early as 2017. - Medicare underfunding increased by 80 percent of GDP by the prescription drug benefit. - FY 2007 budget projects entitlement spending will rise by around 1½ percent of GDP each decade through 2080. - Policy recommendations: - Central focus on controlling outlays; re-introduce caps on discretionary spending and PAYGO covering entitlements and tax measures. - Revenue options: prioritize base broadening by reducing tax preferences (examples: mortgage interest, employers’ health insurance premiums, state and local tax payments); consider consumption-based indirect taxes (national sales tax, VAT, energy taxation). - Urgency of entitlement reform: re-invigorate Social Security reform (e.g., progressive price indexation) and undertake fundamental Medicare/health-care reform. ### V. External imbalances, current account, and international spillovers - Recent external outcomes and projections: - Current account balance ($ b): 2005 -792; projected 2006 -868; 2007 -935; 2008 -984; 2009 -1035; 2010 -1089; 2011 -1145. - Current account balance (percent of GDP): 2005 -6.3; 2006 -6.5; 2007 -6.7. - 2005 current account widened to a record 6¼ percent of GDP (text summary). - Drivers and valuation: - Real exchange rate: staff estimated overvaluation in the 15-35 percent range (sensitivity to assumptions noted). - Trade shift toward low-cost producers blunted measured effects of real effective exchange rate depreciation. - Global spillovers: - Unanticipated 1 percent undershoot in U.S. growth associated with a ¼ percent slowing in growth elsewhere (WEO forecast errors since 1990). - Dollar assets represent about half of global private sector bonds; shocks to U.S. long-term real rates transmit to foreign rates and emerging market spreads. - Recommended cooperative strategy to reduce disorderly adjustment risk: - Raise U.S. national saving (including ambitious fiscal consolidation). - Greater exchange rate flexibility in emerging Asia. - Continued structural reforms in Europe and Japan. - Multilateral approach with Fund leadership in consultations. ### VI. Housing scenarios, fan‑chart risks, and sensitivity analysis - Fan-chart and scenario framework: - Baseline: real house price growth slows to 5 percent in 2006, implying a drag on GDP growth of approximately ½ percent in 2006 and 2007. - Downside scenario: nominal house prices remain unchanged over the next year (real prices fall moderately), residential investment growth turns negative; assuming a larger housing wealth effect of 10 cents in the dollar, GDP growth expected to fall by 1 percent relative to the 2006 baseline. - Upside scenario: house price inflation and activity in 2006 remain the same as in 2005, implying a ½ percentage point higher GDP growth than in the baseline forecast. - Empirical and cross-country findings: - In the U.K. and Australia—countries with HEW ratios similar to recent U.S. levels—slowing house price inflation led to a manageable rebound in household saving. - If HEW reverted rapidly to its long-term average of around 1 percentage point, regression coefficients imply a temporary boost to household saving of 1 percentage point or so and a negative impact on residential investment for home improvement. ### VII. Selected analytical notes: pensions, territorial taxation, and recent data update - Defined benefit pensions and saving initiatives: - Administration proposals welcomed to strengthen DB plans: reduce disincentives to overfunding, use corporate bond yields to calculate pension liabilities, allow PBGC to set risk-based premiums. - Automatic enrollment in employer-sponsored defined contribution plans with rising contribution schedules supported to boost personal saving; LSAs proposed but net national saving effect uncertain without offsetting deficit reduction. - FASB proposal to include pension accounts in corporate balance sheets expected to increase transparency. - Corporate tax territoriality (WP/06/161) — key points: - Worldwide versus territorial systems defined; U.S. share of worldwide FDI stock around 20 percent. - Foreign taxes paid by U.S. companies on foreign source income in 2001: $44½ billion (about one-third to developing countries). - Moving to territoriality: potential revenue loss from exempting foreign source income but proponents argue possible revenue-neutrality through associated reforms and repatriation effects; effects on FDI location and tax competition could be significant for some recipient countries. - Recent data (note since staff report): - June payroll employment: 121,000. - Unemployment rate: 4.6 percent. - 12-month overall CPI: 4.3 percent; 12-month core CPI: 2.6 percent; 12-month core PPI: 1.9 percent; headline PPI: 4.8 percent. - Hourly wage growth accelerated to close to 4 percent (June). - Trade deficit (May): $63.8 billion. - Long-term bond yields fell about 10 basis points to just over 5 percent since end-June; equity prices down 1½ to 2 percent since end-June. - Futures implied roughly 50 percent probability of a 25 basis point hike at early August FOMC. ### VIII. Staff appraisal and Executive Board guidance (summary) - Growth outlook: soft landing expected but substantial downside and upside risks remain. - Policy prescriptions emphasized: - Careful monetary calibration with clearer inflation communication. - Strengthened financial-sector supervision (GSEs, insurance, pensions) and enhanced surveillance (FSAP, Financial Stability Report). - Decisive fiscal consolidation and entitlement reform to manage aging-related fiscal pressures and global imbalance risks. - Re-introduce caps on discretionary spending and PAYGO rules; prioritize base-broadening revenue measures and consider consumption-based taxes. - Preserve U.S. leadership in trade liberalization and resist domestic protectionism; ensure bilateral FTAs complement multilateral approaches. *Source: IMF staff report excerpts and Executive Board discussions in _cr06279.* ### Executive Summary ...................................................................................................... ### _cr06279 - Executive Summary ### Executive summary: main findings and recommendations - The U.S. economy has remained a key engine of global growth, despite devastating hurricanes, a withdrawal of monetary stimulus, and high energy prices. - Activity has remained robust, supported by strong productivity growth, and buoyant tax revenues seem likely to keep the FY 2006 federal deficit well below initial budget estimates. - The Federal Reserve must steer a delicate course between competing risks: - A cooling housing market, higher energy prices, and an unusually low saving rate could weigh more heavily on activity than expected. - A recent pick up in core inflation and price expectations implies that some further policy firming may yet be needed. - The Fund suggests the Fed provide a more explicit statement of its inflation objective to help further anchor inflation expectations. - Financial sector: innovative and resilient, but reforms could enhance strength and efficiency: - Tighten supervision of the housing GSEs. - Move toward consolidating supervision and regulation of insurance companies. - Reform corporate pension plans. - Publish a regular Financial Stability Report and undertake a Fund FSAP for further insights. - Global imbalances and U.S. fiscal policy: - Firm and vigorous implementation of the cooperative strategy laid out by the IMFC would support an orderly resolution to global imbalances. - The United States’ main task is to boost national saving, including by more ambitious fiscal consolidation. - Achieving a balanced budget, excluding the Social Security surplus, within the next five years would set the federal debt ratio on a firm downward path and reduce the fiscal burden on future generations. - Controlling outlays should remain central to deficit reduction, but revenue measures should not be ruled out. - Re-introduce caps on discretionary spending and pay-as-you-go (PAYGO) requirements covering both entitlement spending and tax measures. - On revenues, priority on reforms that broaden the revenue base by reducing tax preferences; consideration could be given to consumption-based indirect taxes. - Entitlements and health care: - Re-invigorate momentum for entitlement reform, especially Social Security. - Medicare presents a much larger financial shortfall—fundamental reform of the U.S. health care system seems necessary. - Trade policy: - U.S. leadership is key to global trade liberalization and an ambitious conclusion to the Doha Round. - Resist domestic protectionist sentiment and ensure bilateral initiatives complement multilateral approaches. ### I. Outlook and key issues - Recent performance and projection highlights: - Real GDP: 2005 3.5; 2006 3.5; 2007 3.1; 2008 3.2; 2009 3.2; 2010 3.2; 2011 3.2 (percent change from previous period). - Total domestic demand: 2005 3.6; 2006 3.7; 2007 3.1; 2008 3.1; 2009 3.1; 2010 3.1; 2011 3.1. - Private final consumption: 2005 3.5; 2006 3.1; 2007 2.8; 2008 2.8; 2009 2.8; 2010 2.9; 2011 2.9. - Net exports (contribution to growth, NIPA basis): 2005 -0.3; 2006 -0.4; 2007 -0.2; 2008 -0.1; 2009 -0.1; 2010 -0.1; 2011 -0.1. - Unemployment rate (percent): 2005 5.1; 2006 4.8; 2007 4.8; 2008 4.8; 2009 4.8; 2010 4.8; 2011 4.8. - CPI inflation: 2005 3.4; 2006 3.2; 2007 2.6; 2008 2.5; 2009 2.5; 2010 2.5; 2011 2.5. - Unified federal balance (Fiscal year, percent of GDP): 2005 -2.6; 2006 -2.3; 2007 -2.6; 2008 -2.3; 2009 -2.0; 2010 -1.9; 2011 -1.8. - Current account balance (percent of GDP): 2005 -6.3; 2006 -6.5; 2007 -6.7; 2008 -6.7; 2009 -6.7; 2010 -6.7; 2011 -6.7. - Partner country growth (memorandum): 2005 2.8; 2006 3.2; 2007 2.9; 2008 2.9; 2009 2.8; 2010 2.8; 2011 2.8. - Oil prices ($/Barrel, Average petroleum spot price): 2005 53.4; 2006 66.5; 2007 69.8; 2008 68.5; 2009 67.5; 2010 66.8; 2011 66.0. - Growth outlook: - Officials and staff expect a “soft landing,” with growth easing to potential and inflation remaining contained. - Housing market likely to cool due to high valuations and tightening financial conditions, reducing consumption and residential investment impetus. - Strong fundamentals should continue to support business investment. - External deficit likely to remain wide; drag on activity from net exports will lessen as growth abroad strengthens. - Solid productivity growth should accommodate wage gains while containing price pressures. - Risk perceptions: - Staff viewed growth risks as skewed to the downside: abrupt housing slowdown, productivity disappointments, disorderly external adjustment, avian flu, geopolitical events. - Officials regarded risks as relatively balanced; more sanguine about housing slowdown impacts and placed greater weight on upside from business investment, exports, and productivity. - Staff saw inflation risks on the upside from possible productivity slowdown and pass-through of high commodity prices; Fed officials acknowledged commodity risks but were less concerned about productivity downside. ### II. Monetary policy: maintaining noninflationary growth - Policy context: - Policy interest rates have risen to around neutral; output and inflation risks are somewhat skewed. - Monetary policy decisions have become more delicately balanced. - Household spending dynamics: - Household spending has been the main driver of expansion, boosted by the housing boom. - Since the 2001 recession, real consumption and residential investment spending has grown an average ½ percentage point faster than GDP. - Real disposable income growth has been held back by rising energy prices and lackluster employment growth. - Household saving turned negative as spending was financed in part through home equity withdrawal (HEW), which rose to a record 8 percent of U.S. personal income in 2005. - Financing and housing: - Easy financing conditions and flexible U.S. financial markets supported the housing market and a record HEW ratio. - Mortgage securitization helped channel foreign savings into the U.S. housing market and allowed mortgage originators greater flexibility to diversify credit exposures and reduce systemic risk. - Innovative mortgage instruments, low refinancing costs, and access to tax-advantaged home equity loans supported HEW. - Staff observed house prices seemed overvalued and a correction appeared to have started; Chapter 1 of the Selected Issues paper suggests house prices are 15–20 percent above equilibrium. - Fed officials did not disagree but cautioned such estimates are subject to considerable uncertainty and vary across models; empirical evidence suggests personal income and employment conditions tend to dominate long-term interest rates in their impact on house prices. ### III. Preserving domestic and external financial stability - Financial sector resilience and reform priorities: - U.S. financial sector has proven innovative and resilient. - Important reforms to enhance strength and efficiency include: - Tightening supervision of the housing GSEs. - Consolidating supervision and regulation of insurance companies. - Reforming corporate pension plans. - Publishing a regular Financial Stability Report and undertaking a Fund FSAP would provide further insights. - Global imbalances and U.S. policy role: - U.S. policies could reduce risks from financial market volatility stemming from a disorderly resolution of global external imbalances. - The United States has a major role to play in addressing shared responsibility for global imbalances by boosting national saving, notably through fiscal consolidation. ### IV. Fiscal policy: preparing for an aging population - Long-term challenge: - Imminent retirement of the “baby boom” generation makes preparing for population aging a core fiscal challenge. - Entitlement programs are unsustainable without reform. - Medium-term budget policy and recommendations: - Achieve a balanced budget, excluding the Social Security surplus, within the next five years to put federal debt ratio on a firm downward path. - Central focus on controlling outlays, but do not rule out revenue measures. - Re-introduce caps on discretionary spending. - Implement pay-as-you-go (PAYGO) requirements covering both entitlement spending and tax measures. - Revenue-side priority: reforms that broaden the revenue base by reducing tax preferences; consideration of consumption-based indirect taxes possible. - Entitlement reform specifics: - Re-invigorate momentum for Social Security reform based on existing proposals; forming necessary political consensus is the challenge. - Medicare’s much larger financial shortfall calls for fundamental reform of the U.S. health care system. - Box on Fund-U.S. relations (summarized implications): - Consensus on market-based growth fundamentals, but different views on amount of fiscal adjustment needed and role of tax policy. - Administration aims to reduce the deficit to around its long-term average of 1½-2 percent of GDP and has ruled out revenue measures for more ambitious deficit reduction. - Authorities skeptical that U.S. fiscal policy alone can significantly adjust the current account; Treasury analysis cited. - U.S. agreement to discuss modalities of an FSAP is welcome; the United States is the last G-7 country yet to agree to an FSAP. ### V. Trade policy and ODA - U.S. leadership remains key to global trade liberalization and to sustaining momentum for an ambitious Doha Round conclusion. - Policy needs: - Resist domestic protectionist sentiment. - Ensure bilateral trade initiatives complement multilateral approaches. ### VI. Staff appraisal (summary) - Overall assessment: - Outlook: soft landing expected, but substantial downside and upside risks remain across growth and inflation dimensions. - Policy priorities: careful monetary calibration, financial-sector reform and surveillance, and decisive fiscal and entitlement reforms to manage aging-related fiscal pressures and global imbalance risks. *Source: Executive Summary, _cr06279* ### 8. Staff and officials agreed that a cooling in the housing market was likely to ### 8. Staff and officials agreed that a cooling in the housing market was likely to ### Housing market cooling: impact on consumption and investment - Real house price inflation likely to halve to 5 percent in 2006 (yoy) and decelerate further subsequently. - Increasing use of HEW and nontraditional mortgages implied that the sensitivity of consumption to a change in housing wealth would probably be at the upper end of the usual estimate of 3–7 cents per dollar. - Once the impact on residential investment was added, this implied a reduction in GDP growth of around ½ percent of GDP over the next two years (Annex I). - Background work (Annex II.1) indicates in the U.K. and Australia—countries with HEW ratios similar to recent U.S. levels—slowing house price inflation led to a manageable rebound in household saving. - Staff viewed the balance of risks for household spending and residential investment as being on the downside: - A faster deceleration in house prices could further amplify the impact on consumer and residential spending by eroding confidence and increasing strain on borrowers. - These risks were exacerbated by the negative household saving rate and continued high energy prices that reduced discretionary spending power. - Fed officials noted smaller effects were also possible given the surprising strength of consumption over many years. - Private sector analysts projected a relatively small short-term impact on the ratio of debt payments to income from upward movements in variable mortgage rates on adjustable rate mortgages and nontraditional mortgages. ### Business investment outlook - Fed officials viewed recent strength of business investment as consistent with underlying fundamentals: - Any post-IT bubble overhang had been worked off according to trends in the capital/labor ratio and other indicators. - Continuing declines in capital goods prices and strong demand had made capital accumulation attractive. - Purchases of (especially IT) equipment and software had accelerated to levels not seen since the late-1990s. - Real growth in structures had been less strong; given high office vacancy rates, this trend was expected to continue. - Officials and staff agreed business investment could surprise on the upside: - Corporate sector had used high profits and low interest rates to strengthen balance sheets—including through equity buybacks—and accumulate large cash holdings, taking on the unusual position of a net lender. - Extremely strong fundamentals—near-record profit rate, healthy expected earnings growth, low leverage, and the still low cost of capital—suggested upside risks dominated. - An expected weakening in consumption growth could have some dampening effect on business spending. ### Price pressures and inflation risks - Recent uptick in core inflation was viewed as discouraging. - Unemployment rate at 4¾ percent in April had fallen to the low end of most estimates of the NAIRU; capacity utilization was around its long-run average. - Unit labor cost increases had been contained, reflecting solid productivity growth and modest wage gains. - Absence of wage pressures could indicate a lower level of the NAIRU, though globalization and other structural factors could also have played a role. - Staff analysis (Annex II.2) suggests low inflation in recent years has largely reflected a larger-term downward trend, reinforced by cyclical factors including globalization that could reverse as conditions evolve. - Officials expected wage pressures to pick up over the coming year, but did not anticipate much pass-through to overall inflation: - Post-2000 drop in labor market participation was unlikely to be reversed. - Low unemployment could eventually lead to a pick-up in wage growth and some recovery of the labor share of national income. - Strong productivity growth and room for downward adjustments to profit margins meant wage rises would not necessarily translate into inflation. - Commodity price boom posed a short-term inflation risk: - Energy prices seemed to be feeding into inflation expectations; the process might not yet be complete even if energy prices remained at their present level. - Impact of higher oil prices on the economy had been smaller than in the past, partly reflecting reductions in oil intensity of production and productivity growth. - Risk remained of price shocks related to bottlenecks in some key segments of the U.S. energy infrastructure. ### Monetary policy discussions - Technical discussions occurred before the increase in financial market volatility of May-June and attendant inflation concerns. - At the time of the meetings, staff suggested that, at 5 percent, the federal funds rate was close to most estimates of a neutral level. - With inflation risks on the upside, a “risk management” approach could suggest the need for some further tightening, consistent with market expectations of a further rise in the federal funds rate by 25 basis points in subsequent months. - The May 10 FOMC statement noted “a further policy firming may yet be needed to address inflation risks ... the extent and timing of any such firming will depend importantly on the evolution of the economic outlook as implied by incoming information.” - Reflecting heightened inflation concerns, the FOMC raised the Fed funds rate to 5¼ percent on June 29 and observed that while “some inflation risks remain ... any additional firming will depend on the evolution of the outlook for both inflation and economic growth.” - Officials highlighted uncertainty about factors behind low long-term bond yields: - If low term premiums reflected a shift in portfolio preferences toward long-term assets, short-term interest rates would need to be higher to offset the boost to demand from lower long rates. - Conversely, if low term premiums reflected weakening global investment demand or higher global saving, a tightening would not be warranted. - Impact of global financial market integration on the monetary transmission mechanism was difficult to assess; staff suggested increased integration of national bond markets could help explain muted rise in long-term interest rates and subdued response of demand components to U.S. monetary tightening. - Officials did not see rising commodity prices as reflecting broader global inflationary pressures but as a relative price shift from rapid growth in commodity intensive countries such as China. - Mission suggested the Fed could define its inflation objective more explicitly; Fed had established a committee headed by Vice-Chairman Kohn to examine communication policy, including refining the definition of stable prices. - Staff suggested increasing the frequency and forward-looking element of the biannual Monetary Policy Report; officials noted practical difficulties given the size and diversity of the FOMC. ### Preserving domestic and external financial stability - Discussions centered on implications of rapid structural change in U.S. financial markets: - Low credit spreads partly reflected effectiveness of securitization and credit risk transfer techniques. - Increased hedge fund activity had enhanced price discovery and liquidity, but some markets had yet to be fully tested in a less benign environment. - Banks had been adept at responding to changing market conditions: - Banking margins squeezed by a flattening yield curve, but profitability sustained by non-interest income and low charge-off rates. - Even small and regional banks had traded parts of their loan book against mortgage-backed securities, reducing vulnerability to regional shocks. - Staff and officials agreed systemic risks were at a low ebb (Figure 8): - Distance-to-default measures for “large complex banking groups” (LCBGs), the “big five” investment banks, and the insurance sector had recovered to levels last seen in the mid-1990s. - Value-at-risk and implied default risk measures were low despite upticks after May 2005 automotive industry rating downgrades and a large insurer’s accounting problems in late 2004. - Capital adequacy remained strong across the banking sector. - Increased risk-taking could foreshadow deterioration in credit quality: - U.S. corporate credit markets remained strong with low credit spreads, but ample liquidity facilitated pickups in mergers and acquisitions and leveraged buyout activity. - Easier bank lending allowed loan leverage ratios to rise to levels last experienced in 1997. - These trends could signal a turn in the credit cycle, leading to increased market volatility and widening corporate credit spreads. - Subsequent May-June equity market volatility accompanied a global sell-off of riskier assets; impact on corporate bond spreads had been modest. - Financial sector risks related to household borrowing appeared relatively manageable: - Regulatory guidance tightening standards for home equity lending and nontraditional mortgages had led to tighter credit conditions in those markets. - Stress tests indicated borrowers at risk of significant mortgage payment increases remained a small minority, concentrated mostly among higher-income households aware of the attendant risks. - Banks with high concentrations of commercial real estate and construction loans could face difficulty sustaining revenues in a downturn; staff saw risk of a significant dent in banking profitability if the housing market slowed abruptly. - Regulators faced challenges responding to rapid evolution of the financial system: - Supervisors needed to ensure controls and procedures at systemically important institutions and infrastructure providers were robust, with traditional supervisory activities being augmented by a stronger analytical focus on large banks and critical market segments. - Specific regulatory issues discussed: - Hedge funds: leverage and concentration indicators had moderated; mission and officials agreed direct regulation of hedge funds would be ineffective and focus should be on limiting counterparty risk to banks acting as prime brokers and improving financial infrastructure. - Government-sponsored enterprises (GSEs): staff and Treasury agreed on need for rules to reduce size of GSEs’ portfolios given systemic risks; officials were cautiously optimistic Administration proposals to create a new regulator, establish risk-based capital requirements, and limit GSEs’ portfolios would gain congressional support in 2006. - Basel II: bank regulators expected some decline in minimum capital requirements after shift to Basel II norms in 2009; impact on bank balance sheets was uncertain and transition would take several years. - Insurance regulation: Administration had flagged need for a stronger federal role; staff supported this given systemic importance, globalization, and potential for regulatory arbitrage. - Industrial Loan Companies (ILCs): Fed reiterated concern that large commercial firms owning ILCs were not subject to consolidated supervision under the Bank Holding Company Act; mission agreed ILCs should be limited in ability to establish nationwide branch networks. - Mission suggested a Fund Financial Sector Assessment Program (FSAP) could provide international perspective; Treasury and Fed officials were open to participating and discussing modalities. - Team asked whether publishing a Financial Stability Report would improve market understanding; Fed officials responded such a report would not add much value to existing publications by regulators and market participants. *Source: IMF staff and Fed officials discussions as summarized in the provided content.* ### 30. The team welcomed Administration proposals to strengthen defined benefit (DB) ### _cr06279 - 30. The team welcomed Administration proposals to strengthen defined benefit (DB) ### Strengthening Defined Benefit (DB) Plans - Officials welcomed Administration proposals to strengthen defined benefit (DB) plans. - Observations: - Current workers seemed to be accumulating retirement assets at a pace comparable to previous generations. - Given the unfunded liabilities of many DB plans and the Social Security system, maintaining living standards past retirement could become more challenging. - Proposals included: - Reducing disincentives for overfunding of plans. - Using corporate bond yields to calculate pension liabilities. - Allowing the Public Benefit Guaranty Corporation (PBGC) to set risk-based premiums. - Accounting transparency: - Officials were confident that a pending proposal by the Financial Accounting Standards Board (FASB) to include pension accounts in corporate balance sheets would lead to greater transparency and could help improve plan funding. ### Automatic Enrollment, Defined Contribution Plans, and Personal Saving - Agreement: Automatic enrollment in employer sponsored defined contribution plans with rising contribution schedules could help boost personal saving. - Policy actions under consideration: - Officials were seeking to amend pension regulations so that workers could be automatically enrolled in such plans. - Legislation might be required to protect employers from legal sanctions if pension investment returns disappointed. - Tax incentives: - Lifetime saving accounts (LSAs) proposed in the budget could stimulate personal saving. - Officials acknowledged that the net impact on national saving might be small in the absence of offsetting deficit-reduction measures. ### Current Account Deficit: Recent Developments and Drivers - 2005 outcomes: - The current account widened to a record 6¼ percent of GDP in 2005, owing to higher oil prices and the relative strength of U.S. import demand. - The U.S. net foreign liability (NFL) position barely deteriorated in 2005, reflecting effects of the relative strength of foreign equity markets on U.S. residents’ investments, although recent financial market developments may have reversed some of these gains. - Trade and exchange rate observations: - Staff analysis suggests the shift in U.S. trade toward low-cost producers had blunted some of the measured real effective exchange rate depreciation in recent years. - The real exchange rate appeared significantly overvalued; a staff assessment estimated overvaluation in the 15-35 percent range. - Officials cautioned such estimates are highly sensitive to assumptions and that markets are best placed to judge appropriate exchange rate levels. ### Global Spillovers of U.S. Activity and Financial Conditions - Real activity spillovers: - An unanticipated 1 percent undershoot in U.S. growth is associated with a ¼ percent slowing in growth elsewhere (WEO forecast errors since 1990). - Financial market spillovers: - Dollar assets represent about half of global private sector bonds. - Shocks to U.S. long-term real interest rates flow through to foreign rates; emerging market bond spreads appear closely linked to U.S. financial conditions. - Rising gross international investment positions have increased potential for wealth spillovers from changes in the dollar and U.S. asset prices. - External indebtedness and adjustment paths: - Most analysts agree the size of U.S. net international liabilities is growing at an unsustainable rate. - Possible resolutions include a significant—and possibly abrupt—adjustment of the dollar or a gradual adjustment of global saving and investment balances. - U.S. monetary and fiscal policies have international spillovers; abundant international liquidity has put downward pressure on global bond yields and supported a search for yield. ### Risks and Needed Multilateral Response - Outlook for current account: - Officials agreed the current account deficit seemed likely to widen further. - Exports needed to grow almost twice as fast as imports simply to keep the deficit unchanged, which was difficult given estimates placing the income elasticity of U.S. imports as up to double that of exports. - Growing foreign indebtedness and rising U.S. interest rates implied adverse debt dynamics, with the investment balance expected to turn negative in 2006. - Risk assessment: - Officials remained relatively sanguine about the risk of a disorderly adjustment, citing well-placed U.S. financial markets to intermediate global savings and recent dollar strength implying demand for U.S. securities was not satiated. - Staff noted market expectations implied a relatively sanguine view of risks of future dollar weakness; dollar risk premiums have varied widely but have not consistently risen with increases in net foreign liabilities. - Recommended cooperative strategy: - The mission cautioned about risks of a “disorderly” resolution and emphasized the need for a cooperative global adjustment strategy. - Key elements: raising U.S. national saving (including by more ambitious fiscal consolidation), greater exchange rate flexibility in emerging Asia, and continued structural reforms to boost growth in Europe and Japan. - Officials stressed a multilateral approach and supported the Fund’s leadership in multilateral consultations. - Officials were concerned surplus countries had not accepted the need to boost domestic demand relative to output. ### Fiscal Policy: Preparing for an Aging Population — Long-Term Challenge - Consensus: The long-term fiscal outlook was unsustainable and entitlement reform was needed. - Demographic and health care pressures: - Population aging and rising health care costs are projected to place an ever increasing burden on public retirement and health systems. - The FY 2007 budget projects spending on entitlement programs (including Social Security and Medicare) will rise by around 1½ percent of GDP each decade through 2080. - Specific fiscal gaps and timing: - The Trustees estimate the 75-year funding gap of the Social Security and Medicare systems at 325 percent of GDP. - The Social Security system—presently running a cash surplus of 1½ percent of GDP—is projected to fall into deficit as early as 2017. - The underfunding of the Medicare system is much larger, and has been increased by 80 percent of GDP by the prescription drug benefit. - Medicaid has a large implicit funding gap; rapid outlay increases would make it increasingly difficult for states to meet balanced-budget requirements without spending cuts elsewhere, increased tax revenues, or higher federal transfers. - Political context: - Social Security reforms have stalled in Congress. - The Administration proposed establishing a bipartisan commission to examine broad reform of entitlement programs, but little subsequent progress was reported. ### Medium-Term Budget Policy and Pathways to Sustainability - Recent performance: - Revenue buoyancy and expenditure discipline had improved fiscal prospects. - Tax receipts through April exceeded projections, and indications were that the year’s deficit would fall below 2½ percent of GDP, under the budget projection of 3¼ percent. - Objective of “halving the deficit” relative to the $540 billion (4½ percent of GDP) forecast for FY2005 seemed likely to be met by FY 2008, a year ahead of schedule. - Staff view and recommended ambition: - Staff welcomed improved fiscal performance and saw opportunity for a more ambitious medium-term target for deficit reduction. - Budget projections showing a deficit reduction to 1¼ percent of GDP by FY 2011 appeared unambitious, implying an adjustment of only around 1 percentage point relative to the likely outturn for FY 2006. - Balancing the budget excluding Social Security: - Achieving a balanced budget excluding Social Security over five years, coupled with entitlement reform, would restore long-term fiscal sustainability. - Staff analysis suggested annual consolidation of some ¾ percent of GDP would be required; the impact on U.S. and global demand seemed manageable. - Concerns about assumptions: - Officials emphasized commitment to deficit reduction through expenditure restraint. - Staff cautioned that the assumed discipline on discretionary spending in the budget appeared optimistic and relied on measures previously rejected by Congress, ignored costs of funding operations in Iraq and Afghanistan beyond FY 2007, and relied on reinstatement of PAYGO rules with questions on coverage of tax cuts. - Options to raise the revenue ratio: - Base broadening: Gradually reduce ill-targeted tax breaks, including for mortgage interest payments, employers’ contributions to health insurance plan premiums, and state and local tax payments; consider raising Social Security and Medicare contribution limits. - Energy taxation: Could yield significant revenues and support energy security and environmental objectives by lowering consumption. - A national VAT: An indirect consumption tax would tend to maintain buoyancy as the workforce retires and, by avoiding taxation of factor incomes, would encourage private saving and investment. ### Long-Term Scenario Findings (Box 3 summary) - CBO baseline (Scenario A): - Assumes moderation in annual excess health cost growth from 2½ percentage points at present to 1 percentage point after 2030. - Assumes sharp drop in discretionary spending from 10.2 percent of GDP to 7.6 percent in 2030 and 6.6 percent by 2050. - Maintains the revenue ratio at its long-term average of 18.3 percent of GDP. - This scenario puts federal entitlement spending on an unsustainable path. - Entitlement reform alone (Scenario B): - Eliminating annual excess cost growth for Medicare and Medicaid by 2050 and progressive indexation of Social Security benefits reduces the rise in health care outlays but does not achieve fiscal sustainability. - Rapid buildup of debt remains due to doubling of the old-age dependency ratio. - Combined approach (Scenario C): - Entitlement reform plus balancing the budget excluding Social Security by FY 2011 (a 3 percent of GDP improvement in the nonentitlement primary balance maintained subsequently) achieves long-term fiscal sustainability. - Alternatives: - To maintain the revenue ratio at its historical average, immediate elimination of excess cost growth in Medicare and Medicaid would be required, presumably through benefit reductions, plus larger cuts to nonentitlement spending. - More gradual deficit reduction (e.g., rescinding the 2001 and 2003 tax cuts and leaving the AMT unreformed) would lead to a higher debt ratio and increase the needed long-term fiscal consolidation by slightly over 2 percentage points of GDP. *Source: _cr06279 - 30. The team welcomed Administration proposals to strengthen defined benefit (DB)* ### 44. Officials responded that it was inadvisable to set a medium-term deficit objective to ### _cr06279 - 44. Officials responded that it was inadvisable to set a medium-term deficit objective to ### Entitlement reform: findings and proposals - Officials judged it inadvisable to set a medium-term deficit objective to address spending pressures whose size was uncertain and whose solutions were largely political. - The core policy choice identified: whether U.S. society would tolerate higher taxes to finance existing entitlement programs or accept lower entitlement benefits per capita. - The Administration opposed revenue increases to finance deficit reduction because of their detrimental supply-side effects. - Observations on revenue-to-GDP dynamics: - The ratio of revenues to GDP would tend to rise gradually over time through bracket creep. - Historically, the tendency has been to respond with tax cuts, and the ratio had not deviated from its long-term average of slightly over 18 percent of GDP for an extended time in the postwar period. - Health care: - U.S. health care spending was around 15 percent of GDP, well above the OECD average, with the public sector responsible for around half of the total. - Officials agreed on the need for major reform to contain costs and on addressing third-party insurance’s tendency to insulate consumers from rising health costs. - Policy measures introduced or encouraged: health savings accounts (HSAs) coupled with tax incentives for high deductible health care insurance plans; improvements in information on quality and effectiveness of procedures/services. - The Administration encouraged state initiatives to increase the efficiency of the Medicaid program and noted greater state flexibility alongside tightening of the definition of expenses eligible for federal matching grants. - Social Security: - The Administration was open to a range of reforms. The President endorsed slowing benefit growth by linking payments to a sliding combination of wage and price indexing, which would more than halve the 75-year funding gap. - Consideration would be given to additional proposals toward the end of the 75-year funding window, such as indexing benefits to longevity and raising the cap on payroll taxes, although raising payroll tax rates would not be acceptable. - The President proposed creating Personal Retirement Accounts without raising payroll taxes; other approaches were not rejected. - Staff view: key priority is to ensure reforms are not delayed, since delay increases the cost of adjustment. ### Trade policy and official development assistance (ODA) - Doha Round and multilateral trade: - Officials stressed that an ambitious completion of the Doha round remained a priority for the Administration. - With trade promotion authority (TPA) expiring mid-2007, there was a need to wrap up negotiations by the end of this year. - Staff noted reductions in U.S. agricultural subsidies, and similar subsidies elsewhere, would need to be a key component of a multilateral deal. - Officials stated that the United States had made an ambitious proposal, including the ultimate elimination of agricultural tariffs and trade-distorting subsidies, and expressed disappointment with others’ unwillingness to reciprocate. - Officials cautioned it would be impossible to gain Congressional support for lower U.S. agricultural subsidies without a corresponding increase in market access. - Bilateral FTAs: - U.S. FTAs have been concluded or are under negotiation with 29 countries; only four were in place in 2002. - Officials saw U.S. bilateral FTAs as a complement to multinational negotiations; staff expressed concern about their proliferation and potential to undermine multilateral trade. - Staff recommended simple and liberal rules of origin and suggested scope for mutual restraints or open-access clauses to allow accession to existing FTAs. - Protectionism and China: - Staff emphasized resisting mounting protectionist sentiment. - Recent Congressional proposals targeted at China risked hurting workers in both countries while having little impact on the U.S. trade balance. - Officials considered United States/Chinese trade relations healthy, stressed WTO compliance, and noted the Administration favored shifting terminology from “manipulation” to the more analytically precise “misalignment.” - Treasury officials noted the May semiannual report on economic and exchange rate policies had not designated China as a currency manipulator. - Official development assistance (ODA): - The U.S. share of official development assistance in GDP remains one of the lowest among industrial countries. - The budget requested a modest increase for FY 2007; OECD estimates suggested this could be insufficient to meet the Gleneagles G-8 commitments on increased aid to Africa, the Millennium Challenge Account, and initiatives on HIV/AIDS and malaria. - Officials suggested the United States was well on its way to meeting these commitments, especially with large increases in Millennium Challenge Corporation financing programmed for the next few years. - Officials stressed overall U.S. assistance (including remittances and other private capital flows) remained several times the level of official ODA and was more important for the United States than for other countries. ### Staff appraisal: macroeconomic outlook, fiscal policy, and financial sector recommendations - Macroeconomic outlook and monetary policy: - The U.S. economy remained a key engine of global growth despite devastating hurricanes, a withdrawal of monetary stimulus, and high energy prices. - Activity remained robust, supported by strong productivity growth; buoyant tax revenues seem likely to keep the FY 2006 federal deficit well below initial budget estimates. - Prospects point to growth gradually easing to a more sustainable rate. - The Federal Reserve faces competing risks: a cooling housing market, higher energy prices, negative household saving rate versus a pickup in core inflation and expectations and a further drop in the unemployment rate. - Given the importance of anchoring inflation expectations, policymakers have warned some further policy firming may yet be needed. - Staff recommended the Fed provide a more explicit statement of its inflation objective and consider providing more frequent Monetary Policy Reports with greater focus on future developments to increase transparency. - Financial sector resilience and reforms: - The U.S. financial sector has proven innovative and resilient and appears well-positioned as the credit cycle turns, though credit derivatives markets merit close monitoring. - Areas for reform: - Carry forward Administration proposals to strengthen supervision of the housing GSEs and limit the size of their balance sheets to contain systemic risk. - Improve funding of the PBGC, strengthen accounting and transparency of defined benefit pension plans, and improve incentives for participation in defined contribution plans. - Address fragmented supervision and regulation of insurance companies and move toward a more uniform approach. - Undertake a Fund FSAP and publish a regular Financial Stability Report to provide further insights. - Fiscal consolidation and global imbalances: - The United States has a major role in implementing the cooperative strategy laid out by the IMFC; orderly resolution of imbalances would be supported by ambitious fiscal consolidation to boost national saving. - Delaying adjustment will mean continued increases in U.S. external indebtedness, heightening the risk of sharp disruptions to exchange rates, financial markets, and growth. - Medium-term fiscal anchor recommendation: - With buoyant revenues supporting deficit reduction, the time is opportune to establish a more ambitious medium-term fiscal anchor. - Staff recommended achieving a balanced budget, excluding the Social Security surplus, within the next five years to set the federal debt ratio on a firm downward path and provide room to phase in entitlement reforms. - Given current budget projections, this would require consolidation of around ¾ percentage point of GDP a year. - Fiscal consolidation measures (expenditure and revenue): - Expenditure-side: - Controlling outlays should remain central, but sustaining discipline may be difficult given defense and emergency spending pressures. - Merit seen in re-introducing caps on discretionary outlays and pay-as-you-go (PAYGO) requirements covering both entitlement spending and tax measures. - Revenue-side: - It may be difficult to sustain the significant reductions in marginal tax rates of recent years while meeting fiscal burdens from population aging. - Priority should be on reforms that broaden the revenue base by reducing tax preferences, including those for mortgage interest payments, employers’ contributions to health insurance plan premiums, and state and local tax payments, as suggested by the President’s Advisory Panel. - Consideration could be given to consumption-based indirect taxes—such as a national sales tax, a VAT, or energy taxation—to maintain revenue buoyancy as workers retire. - Entitlement reform urgency: - Re-invigorating momentum for entitlement reform is critically important. - The Administration’s suggestion of “progressive price indexation” was useful; policymakers must form consensus to develop packages to place Social Security on a sustainable basis. - The Medicare financial shortfall dwarfs that of Social Security, especially with the addition of the new prescription drug benefit; broader, fundamental reform of the U.S. health care system seems necessary despite measures like high-deductible plans. - Trade and ODA leadership: - U.S. leadership is key to global trade liberalization and concluding the Doha Round. - The United States must resist domestic protectionist sentiment and ensure bilateral trade initiatives complement, rather than substitute, multilateral approaches. - Further boosting ODA would help achieve ambitious goals to support the poorest countries. *Source: IMF staff report excerpt (_cr06279).* ### 62. It is expected that the next Article IV consultation with the United States will be held ### _cr06279 - 62. It is expected that the next Article IV consultation with the United States will be held ### Macroeconomic outlook and key projections - Real GDP (percent change, annual rate / selected series from Table 1 and Table 2): - United States: 2005: 3.5; 2006: 3.5; 2007: 3.1 (Table 1: national production and income; Table 2: Real GDP series shows 2005: 4.2, 2006: 3.5, 2007: 3.5 in a different series — staff and source tables present consistent short-term strength). - Components of demand (Table 1): - Private final consumption: 2005: 3.5; 2006: 3.1; Q1–Q4 2006 quarterly entries include 2.8, 2.9, 2.9, 4.1 (Table 1 quarterly breakdown). - Gross fixed domestic investment: 2005: 7.2; 2006: 6.1; 2007: 4.4; 2008: 4.9 (Table 1). - Price indicators (Table 1 and Table 2): - CPI inflation: 2005: 3.4; 2006: 3.2; 2007: 2.6 (Table 1); Administration projection CPI inflation (calendar-year basis) shown as 2.7 for 2004, 3.4 for 2005, 3.0 for 2006 (Table 5). - GDP deflator: 2005: 2.8; 2006: 2.8; 2007: 2.0 (Table 1). - External sector (Table 1 and Table 3): - Current account balance ($ b): 2005: -792 (Table 3); projections show continuing large deficits: 2006: -868; 2007: -935; 2008: -984; 2009: -1035; 2010: -1089; 2011: -1145 (Table 1, balance of payments projections). - Current account balance (% of GDP): 2005: -6.3; 2006: -6.5; 2007: -6.7 (Table 1 and Table 3 percent series). - Saving and investment (Table 1): - Gross national saving: 2005: 13.4; 2006: 14.2; 2007: 14.2 (Table 1). - Gross domestic investment: 2005: 20.1; 2006: 20.7; 2007: 20.9 (Table 1). ### Fiscal stance and medium‑term fiscal projections - Unified balance (FY and calendar adjustments) and debt (Table 5): - Administration FY 2007 Budget outlays: 2004: 19.9; 2005: 20.1; 2006: 20.8; 2007: 20.1; later years shown through 2011 at similar levels (percent of GDP). - Administration unified balance (percent of GDP): 2004: -3.6; 2005: -2.6; 2006: -3.3; 2007: -2.6 (Table 5). - Staff-adjusted unified balance (percent of GDP): 2004: -3.6; 2005: -2.6; 2006: -2.3; 2007: -2.6; 2008: -2.3; 2009: -2.0; 2010: -1.9; 2011: -1.8 (Table 5). - Unified balance (billion dollars, staff adjusted): 2004: -412.0; 2005: -318.0; 2006: -296.0; 2007: -353.6; 2008: -329.2; 2009: -313.7; 2010: -307.5; 2011: -303.9 (Table 5). - Debt held by the public (percent of GDP): Administration path shows 37.2, 37.3, 38.5, 39.0, 38.5, 37.9, 37.2, 36.5 for 2004–2011; staff-adjusted path shows similar levels (Table 5). - Fiscal sustainability risks: - Staff highlights that “given the economy's cyclical position, the U.S. fiscal deficit remains large” and projects that entitlement spending pressures (Social Security, Medicare, Medicaid) will drive rapidly increasing fiscal commitments over the medium to long run (Figures 11–12). ### Financial sector and vulnerability indicators - Interest rates and yields (Table 1 and Figures): - Three-month Treasury bill rate: historical and projected values include 3.2, 5.0, 5.3 in the short run (Table 1 shows series with quarterly entries such as 5.3, 5.2, 5.3). - Ten-year government bond rate: series includes 4.3, 5.2, 5.8, 6.0, 6.0, 6.0 in different years and quarters (Table 1). - Banking and corporate sector soundness (Table 4; Figures 4, 7, 8): - U.S. banking sector indicators show total assets rising through 2005: 5,443; 5,735; 6,246; 6,552; 7,077; 7,601; 8,414; 9,040 (Table 4). - Problem loans to total loans and leases: low and declining in recent years (Table 4 shows 1.0, 1.0, 1.1, 1.4, 1.5, 1.2, 0.9, 0.8). - Return on equity and return on assets remain strong: Return on equity series includes 13.9, 15.3, 14.0, 13.1, 14.5, 15.3, 13.7, 12.9; Return on assets around 1.2–1.4 (Table 4). - Figures emphasize strong profitability and capitalization for large complex banking groups (LCBGs), constrained increases in net interest margins, high noninterest income, benign market risk indicators, and generally high credit quality. ### Housing market, household balance sheets, and consumption - Housing and household sector dynamics (Figures 2–3): - The saving rate has turned negative as wealth recovered from post-bubble losses; home equity withdrawal has risen to record levels and has been used in part to finance acquisition of financial assets (Figure 2). - Residential investment and house price dynamics: staff baseline assumes real house price growth will slow to 5 percent in 2006 (Annex I). - House sales have slowed in recent months; inventories and mortgage applications show moderation; house prices remain elevated relative to rents and fundamentals, especially in the Northeast and West (Figure 3). - Household credit and risk indicators: - Mortgage debt has risen sharply; homeowners' financial obligations and measures of loan delinquency remain within historical ranges (Figures 2 and 7). ### External imbalances and international competitiveness - Current account and trade (Table 3; Figures 9–10): - The current account deficit widened to -792 ($ b) in 2005 and is projected to remain large (Table 3). - The merchandise trade deficit and balance on invisibles drive the overall current account gap (Table 3 shows merchandise trade -783 in 2005). - The dollar has depreciated since 2002, particularly against industrial countries, but this depreciation has not reduced the trade deficit, possibly due to a shift toward imports from low-cost developing countries (Figures 9–10). ### Risks, fan‑chart assessment, and downside scenarios - Fan chart methodology and staff risk assessment (Annex I): - Staff used the standard deviation of forecast errors from the April World Economic Outlook over 1992–2005 and assessed the balance of risks across housing, labor productivity, financial conditions (downside), and corporate spending (upside). - The balance of risks for 2006 implies that the average (mean) forecast for growth is ¼ percent below staff’s most likely (mode) forecast, with the difference rising in 2007 (Annex I). - Housing-related scenarios (Annex I): - Baseline: real house price growth slows to 5 percent in 2006, implying a drag on GDP growth of approximately ½ percent in 2006 and in 2007. - Downside scenario: nominal house prices remain unchanged over the next year (real prices fall moderately), residential investment growth turns negative; assuming a larger housing wealth effect of 10 cents in the dollar owing to rapid slowdown in home equity withdrawal, GDP growth is expected to fall by 1 percent relative to the 2006 baseline. - Upside scenario: house price inflation and activity in 2006 remain the same as in 2005, implying a ½ percentage point higher GDP growth than in the baseline forecast. - Other risks to inflation and activity: - Risks to inflation are biased upward—downside from lower activity is offset by potential boosts to unit labor costs from slower-than-expected productivity growth; upside risk from the possibility that high oil costs are passed through to prices (Annex I). ### Staff analytical emphasis and policy implications (as presented in the source) - Maintain vigilance on downside risks to growth stemming from a potential housing slowdown and related declines in household wealth and home equity withdrawal (Annex I; Figures 2–3). - Address fiscal vulnerabilities over the medium and long term, given large cyclical deficits and projected increases in entitlement spending (Figures 11–12; Table 5). - Monitor external financing patterns and persistent current account deficits, and assess implications of global imbalances and evolving capital flow composition (Table 3; Figures 9–10). - Continue monitoring financial sector soundness despite currently benign indicators, focusing on corporate pension liabilities, securitization trends (notably home equity–related), and market segments where hedge funds and other nonbank players are significant (Figures 7–8). *Source: IMF staff report content as presented in the supplied PDF excerpt._cr06279 (selected tables, figures, and annexes)._* ### 1. Is Housing Wealth an ‘ATM’? The Relationship between Household Wealth, ### 1. Is Housing Wealth an ‘ATM’? The Relationship between Household Wealth, Home Equity Withdrawal, and Saving Rates ### Summary - Paper authors: Vladimir Klyuev and Paul Mills (WP/06/162). - Central question: whether increases in home equity withdrawal (HEW) have financed consumption (acting as an “ATM”) or been used to acquire financial assets, and how HEW relates to household saving rates and household wealth. - Focus: four countries with similar trends in home ownership, personal wealth, and saving—United States, Australia, Canada, and the United Kingdom—to inform likely paths for U.S. HEW and household saving. ### Definition and context - HEW defined as net new household borrowing secured on dwellings in excess of actual investment in housing. - U.S. experience highlighted: HEW increased from around 1 percent of U.S. net disposable income in the early 1990s to 9 percent in 2005; over the same period the ratio of household saving to disposable income fell from 7 percent to minus 0.5 percent. ### Trends in HEW (cross-country evidence) - Financial innovation has improved access to home equity across all four countries: relaxed borrowing constraints, lower refinancing costs, and lower transactions costs—illustrated by the increasing share of secured credit in household debt in the United States. - Liquidity of home equity may reduce consumption volatility and increase attractiveness of homeownership as a store of value. - Cross-country differences in HEW patterns: - United States: HEW on an upward trend since the mid-1990s; HEW tends to rise with housing market turnover and real house price inflation. - United Kingdom and Australia: HEW exhibited a more cyclical pattern; Australia also shows some trend increase. - Canada: Household sector in aggregate has almost never withdrawn equity from housing assets. - Survey evidence on uses of HEW (U.S., U.K., Australia): - Acquisition of financial assets and repayment of other debts were the principal uses. - About 15–25 percent of withdrawn equity used to finance consumption. - A similar share used for home improvement (counts as residential investment and is not included in national accounts definition of HEW). - Aggregate data linkage: - The net acquisition of financial assets by households does not show a clear synchronous rise with HEW in the United States, Australia, and the United Kingdom. - In Canada, household saving declined against the backdrop of growing home equity injection and a declining flow into net financial assets. ### Regression results - Long-run: HEW does not affect household saving rates in the long run, including in the United States. - Long-run determinants of personal saving rates identified: - Ratio of household net worth to disposable income. - Real interest rate. - Inflation rate. - A time trend (likely reflecting financial market liberalization and innovation) helps explain the U.S. saving rate path. - Short-run: HEW may have a notable temporary effect on saving. - Changes in HEW are estimated to lead to a 15–20 cents in the dollar temporary offset on U.S. household saving, consistent with survey evidence, although the impact is not statistically significant for the United States. - Country-specific regression findings: - United Kingdom: larger and statistically significant short-run effect. - Australia and Canada: estimated effects somewhat smaller than in the United States and insignificant. ### Policy implications - Access to housing wealth via HEW appears to have short-term impact on household saving; long-term trends are dominated by changes in household wealth and real interest rates, reflecting increasing fungibility of wealth forms over time. - Mortgage market innovation (lower transaction costs, easier access to home equity): - May increase the level and volatility of HEW. - Should yield macroeconomic benefits by allowing households to smooth consumption more effectively. - Implication for a cooling housing market: - A likely fall in HEW should support some rise in the U.S. household saving rate. - Recent U.K. and Australian experience indicates HEW could fall significantly as housing markets decelerate. - If HEW were to rapidly revert to its long-term average of around 1 percentage point, regression coefficients imply: - A temporary boost to household saving of 1 percentage point or so. - A negative impact on residential investment spending on home improvement. *Source: IMF staff summary of “Is Housing Wealth an ‘ATM’? The Relationship between Household Wealth, Home Equity Withdrawal, and Saving Rates” by Vladimir Klyuev and Paul Mills (WP/06/162).* ### 5. Moving to Territoriality? Implications for the United States ### 5. Moving to Territoriality? Implications for the United States and the Rest of the World ### Overview - Author: Peter Mullins (WP/06/161). - Issue: Proposal to move the U.S. corporate tax from a worldwide basis to a territorial basis. - Definitions: - Worldwide tax system: profits earned abroad are taxed in the United States when repatriated, with a credit for foreign taxes paid. - Territorial tax system: profits earned abroad would be exempt in the United States. ### Impact on the United States - Arguments in favor of territorial taxation: - Increased competitiveness of U.S. firms in foreign markets because foreign earnings would not be taxed at U.S. corporate rates, which are described as relatively high by international comparison. - Removal of a distortionary incentive to retain profits offshore, which could increase domestic investment. - Elimination of some avoidance opportunities. - Greater simplicity. - Arguments against territorial taxation: - Would encourage U.S. firms to invest abroad rather than in the United States. - Gains from simplification would be minimal because many current complex rules would still apply under a territorial system. - Some existing problems (such as transfer pricing) would be exacerbated. - Assessment: - The potential benefits to the United States from adopting a territorial system are described as not clear cut. - An alternative often proposed: retain the worldwide system but remove the current deferral of tax until repatriation (and hence the bias against repatriation) and tighten foreign tax crediting rules. ### Impact on the Foreign Countries - Importance of U.S. actions: - The rest of the world’s interest depends partly on the impact on U.S. FDI abroad. - The United States accounts for around 20 percent of the worldwide stock of FDI. - Relatively small changes in U.S. FDI could have a large impact on some other countries. - Potential outcomes for recipient countries: - Recipient countries would benefit if increased U.S. FDI inflows do not displace FDI from elsewhere, leading to a net gain in revenue. - Impact on foreign tax revenues: - Foreign taxes paid by U.S. companies on foreign source income amounted to $44½ billion in 2001, of which about a third accrued to developing countries. - Three key questions addressed: - Would the territorial system change the level and location of U.S. FDI? - Empirical evidence suggests a U.S. move to a territorial system could lead to changes in the location of FDI (in response to differences in national tax rates) but would leave the overall level of U.S. FDI roughly unchanged. - This result reflects factors including limits on expense deductibility and foreign tax cross-crediting; the tax exemption already provided under the current system (largely through tax deferral); and the possibility that increased U.S. FDI would replace non-U.S. FDI. - Would the territorial system encourage tax competition to attract U.S. FDI? - To the extent countries already compete to attract investment from other countries with territorial systems, the additional impact on tax competition may be limited. - Some countries currently setting tax rates to “soak up” U.S. foreign tax credits may move to a territorial system, which could encourage others to reduce rates to attract more FDI. - Would other countries follow the United States lead and move to a territorial system? - Except in the Latin American region, many emerging markets and developing countries have generally shifted toward territorial taxation, and U.S. adoption could provide further encouragement. - Given the scope for abuse under a territorial system (e.g., related to transfer pricing), the revenue impact could be negative for countries without strong administrative systems. - Most double tax treaties provide for taxes on multinational corporations to be collected by the source country; U.S. treaty partners may feel under pressure to reduce their tax rates to attract U.S. FDI. ### Policy Implications - For U.S. revenues: - A move to territoriality may have tax revenue implications for the United States. - The direct effect of exempting foreign source income would be to reduce tax revenues. - The Tax Panel and other analysts argue the proposal would be largely revenue-neutral or even increase revenues due to: - Possible increase in investment in the United States as a result of earlier profit repatriation. - Effects of other proposed tax changes associated with the territorial system. - For developing countries and tax competition: - A U.S. move could intensify tax competition amongst developing countries. - Countries already competing for FDI from other destinations would be less affected. - Countries where U.S. FDI has traditionally been most important could experience additional pressures on revenues. ### Key Statistics and Projections (selected figures from adjoining sustainability framework tables and charts) - U.S. share of worldwide FDI stock: around 20 percent. - Foreign taxes paid by U.S. companies on foreign source income in 2001: $44½ billion (about one-third to developing countries). - Table 1 (selected lines, in percent of GDP unless otherwise indicated): - Baseline: Net Foreign Asset Position - 2001: -23.1 - 2006: -26.5 - 2011: -50.1 - Change in net foreign asset position (line 2) - 2001: -7.0 - 2006: -6.1 - 2011: -3.6 - Identified external liability-creating flows (line 3) - 2001: 3.6 - 2006: 6.2 - 2011: 7.6 - Current account deficit excluding income flows (line 4) - 2001: 3.6 - 2006: 6.6 - 2011: 7.8 - Net foreign liabilities-to-exports ratio (in percent) - 2001: -232.3 - 2006: -246.1 - 2011: -397.9 - Key macroeconomic assumptions underlying the baseline (selected): - Real GDP growth (in percent) - 2001: 0.8 - 2006: 3.5 - 2011: 3.2 - GDP deflator in US dollars (change in percent) - 2001: 2.4 - 2006: 2.8 - 2011: 2.0 - Nominal external interest rate (in percent) - 2001: 2.9 - 2006: 4.6 - 2011: 4.8 - Growth of exports (US dollar terms, in percent) - 2001: -6.0 - 2006: 12.1 - 2011: 8.3 - Growth of imports (US dollar terms, in percent) - 2001: -5.5 - 2006: 12.4 - 2011: 6.3 - Table 2 (selected public debt and fiscal lines, in percent of GDP unless otherwise indicated): - Baseline: Public sector debt (line 1) - 2001: 38.3 - 2006: 46.7 - 2011: 49.8 - Change in public sector debt (line 2) - 2001: -1.2 - 2006: 0.7 - 2011: 0.0 - Primary deficit (line 4) - 2001: -2.7 - 2006: 0.6 - 2011: -0.7 - Revenue and grants (line 5) - 2001: 30.7 - 2006: 29.4 - 2011: 30.1 - Primary (noninterest) expenditure (line 6) - 2001: 28.0 - 2006: 29.9 - 2011: 29.4 - Public sector debt-to-revenue ratio - 2001: 124.7 - 2006: 158.8 - 2011: 165.5 - Gross financing need (in percent of GDP, line 6) - 2001: 19.9 - 2006: 23.0 - 2011: 23.3 - Gross financing need (in billions of U.S. dollars) - 2001: 2018.9 - 2006: 3051.4 - 2011: 4006.5 - Figure notes (selected): - Figure 1: Net foreign assets in percent of GDP; individual shocks are permanent one-half standard deviation shocks. - Figure 2: Public debt in percent of GDP; individual shocks are permanent one-half standard deviation shocks; one-time real depreciation of 30 percent and 10 percent of GDP shock to contingent liabilities occur in 2006 in certain scenarios. *Italic: Source: _cr06279 - 5. Moving to Territoriality? Implications for the United States (PDF chapter).* ### 1. This note reports on information that has become available since the staff report ### _cr06279 - 1. This note reports on information that has become available since the staff report ### Recent economic and financial market developments - Activity shows a gradual slowing: - June payroll employment rose by only 121,000. - Unemployment rate remained steady at 4.6 percent (household survey indicated stronger growth). - Housing indicators cooled: weaker housing starts and building permits in June. - Retail sales retreated 0.1 percent. - Producer and consumer sentiment softened. - Industrial production increased 0.8 percent in June. - Trade deficit broadly stable at $63.8 billion in May, suggesting an upside risk to the staff’s estimate of real net exports. - Inflation and wages: - 12-month increase in overall CPI: 4.3 percent. - 12-month increase in core CPI: 2.6 percent (core inflation slightly above market expectations). - 12-month core PPI inflation: 1.9 percent (stable and in line with expectations). - Headline PPI inflation rose to 4.8 percent. - Hourly wage growth accelerated to close to 4 percent in June. - Spread between conventional and inflation-indexed 10-year bonds: around 2.6 percent (stable). - Financial markets and policy expectations: - Long-term bond yields decreased by about 10 basis points to just over 5 percent since end-June. - Equity prices fell by 1½ to 2 percent since end-June. - Futures prices suggested roughly 50 percent probability of a 25 basis point hike in the federal funds rate at the early August FOMC meeting. ### Monetary and fiscal developments - Federal Reserve / Monetary Policy Report (MPR) projections presented July 19: - Core PCE inflation projected to ease from around 2¼–2½ percent in 2006 (fourth quarter on fourth quarter) to slightly above 2 percent in 2007. - Economic growth projected to moderate from around 3¼–3½ percent in 2006 (fourth quarter on fourth quarter) to around 3–3¼ percent in 2007. - Chairman acknowledged recent rise in core inflation but expressed confidence inflation would ease later in the year. - Administration’s Mid-Session Review fiscal projections: - FY 2006 unified federal deficit lowered to $296 billion (2¼ percent of GDP) from February estimate of $423 billion (3¼ percent of GDP); forecast identical to staff’s. - Projected deficits for FY2007–11 reduced by ¼–½ percent of GDP relative to prior projections. - Unified federal deficit projected to fall below 1 percent of GDP by FY 2010. - Mid-Session Review stressed urgency of entitlement reform, noting entitlement spending in Social Security, Medicare, and Medicaid is growing faster than the economy and the Nation’s ability to pay. - Table excerpts (United States: Unified Budget, percent of fiscal year GDP): - FY 2005: Outlays 20.1; Net interest expense 1.5; Revenue 17.5; Unified balance -2.6 - FY 2006 (Mid-Session Review): Outlays 20.6; Net interest expense 1.7; Revenue 18.3; Unified balance -2.3 - FY 2007 (Mid-Session Review): Outlays 20.1; Net interest expense 1.8; Revenue 17.7; Unified balance -2.4 - FY 2010 (Mid-Session Review): Outlays 18.8; Net interest expense 1.8; Revenue 18.1; Unified balance -0.8 - Staff Forecast Unified Balance: -2.3 (FY 2005), -2.6 (FY 2006), -2.3 (FY 2007), -2.0 (FY 2008), -1.9 (FY 2009), -1.8 (FY 2010) - Difference from Mid-Session Review (Staff vs Mid-Session Review): 0.0 (FY 2005), -0.2 (FY 2006), -1.0 (FY 2007), -1.0 (FY 2008), -1.1 (FY 2009), -1.1 (FY 2010) ### Public Information Notice / Baseline outlook and risks - Baseline (staff) short-term outlook: a “soft landing” - Growth easing to potential; inflation remaining contained. - Housing market likely to cool, reducing impetus from consumption and residential investment. - Strong fundamentals support business investment. - External deficit likely to remain wide but drag from net exports expected to lessen as growth abroad strengthens. - Solid productivity growth should accommodate wage gains while containing price pressures. - Downside and upside risks: - Downside: more abrupt housing slowdown, disappointments on productivity, disorderly adjustment to global imbalances, higher oil prices, avian flu, geopolitical events. - Upside (for inflation): larger-than-anticipated productivity slowdown (raising unit labor costs), pass-through of high commodity and oil prices. - Financial markets and institutions: - Financial market innovation and hedging contributed to low credit risk spreads and improved pricing and allocation of credit risk. - Banks remained well-capitalized and highly profitable; systemic risks judged low. - Federal Reserve gradually withdrew monetary stimulus: federal funds rate at 5 percent at Article IV discussions and raised to 5¼ percent after June 28-29 FOMC meeting. - Fiscal outlook: - FY 2006 federal budget deficit likely to outperform initial estimates and fall modestly to 2¼ percent of GDP. - Administration appears on track to achieve goal of halving the federal budget deficit earlier than FY 2009. ### Executive Board assessment and policy recommendations - General assessment: - Directors agreed with staff appraisal: U.S. economy remains a key engine of global growth, supported by strong productivity increases. - Buoyant tax revenues likely to keep FY 2006 federal deficit well below initial estimates. - The Federal Reserve’s measured tightening and clear communications helped keep inflation expectations in check while avoiding pronounced slowdown. - Monetary policy guidance: - Fed will need to steer a delicate course to limit downside risks to activity while ensuring inflation expectations remain anchored. - Some Directors suggested merit in the Fed providing a more explicit statement of its inflation objective; views differed on the value of a formal inflation target. - Suggestion to consider more frequent Monetary Policy Reports with greater focus on future developments. - Financial sector reforms suggested: - Tighten supervision of housing Government Sponsored Enterprises (GSEs). - Reform rules for defined-benefit pension plans. - Consider consolidating supervision and regulation of insurance companies. - Undertake an IMF Financial Sector Assessment Program; consider publishing a regular Financial Stability Report. - Fiscal policy and entitlement reform recommendations: - Urgent need for entitlement reform (Social Security, Medicare, Medicaid). - Most Directors suggested establishing a more ambitious medium-term fiscal anchor given buoyant revenues. - Specific recommendation: balance the budget, excluding the Social Security surplus, within the next five years — requiring consolidation of around ¾ percentage point of GDP a year. - Consider revenue measures that broaden the base by reducing tax preferences (examples noted: mortgage interest payments, employers’ contributions to health insurance plan premiums, state and local tax payments). - Consideration could be given to consumption-based indirect taxes—such as a national sales tax, a VAT, or energy taxation—to maintain revenue buoyancy as workers retire. - Re-introduce caps on discretionary outlays and pay-as-you-go (PAYGO) requirements covering entitlement spending and tax measures to help contain spending pressures. - Health care reform: - Directors noted Medicare financial shortfall dwarfs that of Social Security after addition of the new prescription drug benefit. - High health spending (ratio-to-GDP well above the OECD average) suggests fundamental reform of the U.S. health care system may be necessary. - External imbalances and global role: - Directors warned of risks from a disorderly unwinding of global imbalances; boosting U.S. national saving through ambitious fiscal consolidation is important. - U.S. leadership remains key to global trade liberalization; caution against domestic protectionism and ensuring bilateral initiatives complement multilateral approaches. - Directors called for further increases in U.S. overseas development assistance (noting it remains one of the lowest among industrial countries as a proportion of gross national income). ### Key quantitative indicators (selected, as reported) - Labor and activity: - June payroll employment: 121,000. - Unemployment rate: 4.6 percent (June; also reported just above 4½ percent in text). - Industrial production (June): +0.8 percent. - Prices and wages: - 12-month overall CPI: 4.3 percent. - 12-month core CPI: 2.6 percent. - 12-month core PPI: 1.9 percent. - Headline PPI: 4.8 percent. - Hourly wage growth: close to 4 percent (June). - 10-year conventional vs inflation-indexed spread: around 2.6 percent. - External and fiscal: - Trade deficit (May): $63.8 billion. - FY 2006 unified federal deficit (Mid-Session Review): $296 billion (2¼ percent of GDP). - Prior February estimate for FY 2006 unified federal deficit: $423 billion (3¼ percent of GDP). - Staff and Mid-Session Review unified balance examples (percent of fiscal year GDP): see table excerpt in Monetary and fiscal developments section. - Longer-run and historical indicators (Table 1 highlights): - Real GDP growth: 1999 4.4; 2000 3.7; 2001 0.8; 2002 1.6; 2003 2.7; 2004 4.2; 2005 3.5 - Unemployment rate (percent): 1999 4.2; 2000 4.0; 2001 4.7; 2002 5.8; 2003 6.0; 2004 5.5; 2005 5.1 - CPI inflation (annual change): 1999 2.2; 2000 3.4; 2001 2.8; 2002 1.6; 2003 2.3; 2004 2.7; 2005 3.4 - Current account balance (billions): 1999 -300; 2000 -415; 2001 -389; 2002 -472; 2003 -528; 2004 -665; 2005 -792 - Current account balance (percent of GDP): 1999 -3.2; 2000 -4.2; 2001 -3.8; 2002 -4.5; 2003 -4.8; 2004 -5.7; 2005 -6.3 - Gross national saving (share of GDP): 1999 18.1; 2000 18.0; 2001 16.4; 2002 14.2; 2003 13.4; 2004 13.4; 2005 13.4 - Gross domestic investment (share of GDP): 1999 20.6; 2000 20.8; 2001 19.1; 2002 18.4; 2003 18.5; 2004 19.6; 2005 20.1 *IMF Executive Board — Article IV consultation summary and staff note as of July 24, 2006.* --- _Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2006/_cr06279.pdf_