Mission Concluding Statement 

Concluding Statement of the 2012 Article IV Mission to The United States of America

July 3, 2012

Webcast of the press conference

The U.S. recovery remains tepid and subject to elevated downside risks, in light of financial strains in the euro area and uncertainty over domestic fiscal plans. Against this background, policies need to decisively tackle medium-term challenges while using the available room to support the recovery. Specifically, it is critical to ensure a pace of fiscal adjustment in the short run that is supportive of the recovery, removing the threat of a very large fiscal adjustment in 2013, and to adopt a credible medium-term plan restoring fiscal sustainability. Monetary policy conditions appropriately remain very accommodative, with some room for further easing should the outlook deteriorate. Aggressive implementation of the measures proposed by the Administration to speed up the housing recovery could yield sizable benefits to the broader economy. Good progress has been made in reforming the U.S. financial system, but vulnerabilities remain and appropriate resources should be devoted to complete and implement the new regulatory framework and monitor systemic risk.

1. The U.S. recovery remains tepid. After rebounding in the second half of 2011, growth slowed to around 2 percent in the first half of this year. Strong headwinds persist on private consumption, as households continue to deleverage. Residential investment has picked up and house prices have stabilized recently, but remain at depressed levels. Job creation has slowed since early 2012, and the employment-to-population ratio remains substantially below pre-recession levels. Business fixed investment also seems to have lost some momentum, despite favorable financial conditions for the cash-rich corporate sector—large firms can tap bond markets at low rates and enjoy easy access to bank credit. In contrast, access to mortgage credit is still tight for households, notwithstanding historically low rates. Exports have been a bright spot in the recovery but have recently been hampered by some slowdown in foreign demand, particularly in Europe.

2. Growth is likely to remain modest in the next two years, constrained by household deleveraging, fiscal restraint, and subpar global demand. Staff expects growth to be 2 percent in 2012 and about 2¼ percent in 2013. Consumption is expected to be held back by households continuing to repair their balance sheets amid a sluggish recovery of house prices, while weak growth in U.S. trading partners and the appreciation of the dollar are likely to weigh on exports. Staff’s central scenario assumes that the fiscal sector will restrain growth by 1 and 1¼ percentage points in 2012 and 2013, respectively, on account of expiring stimulus measures, such as the payroll tax relief and investment incentives, accompanied by spending restraint. With inflation kept in check by the sizable economic slack, and unemployment projected to decline only slowly, monetary policy is expected to remain accommodative for an extended period.

3. Risks surrounding this forecast are tilted to the downside:

• The United States remains vulnerable to contagion from an intensification of the euro area debt crisis. U.S. financial institutions have limited direct claims on the euro area periphery, but strong financial linkages with the core euro area. Financial stresses in the region may affect the United States mainly via a generalized increase in risk aversion and lower asset prices (including for U.S. multinational firms with substantial sales in the euro area) even though safe haven flows would likely reduce yields on safe assets, notably U.S. Treasuries. Lower demand in the euro area would reduce U.S. exports to the region, while U.S. dollar appreciation on safe haven flows would hurt exports more generally.
• On the domestic front, failure to reach an agreement on near-term tax and spending policies would trigger a severe fiscal tightening in 2013, threatening the recovery. A fiscal consolidation of around 4 percent of GDP in 2013 (in line with current law) could reduce annual growth to well below 1 percent, with negative growth early next year and significant negative repercussions on an already fragile world economy. Meanwhile, the federal debt ceiling will need to be raised in early 2013, bringing back the risk of heightened uncertainty and financial market disruption.
• There are also upside risks, however. Capital investment may turn out to be stronger than in staff’s forecast (particularly in a less uncertain environment), given the strong balance sheets of non-financial corporations. A more positive outlook for the housing market can also be envisaged, with a faster-than-expected recovery in housing starts associated with pent-up demand. The recovery could also strengthen if the policy measures aimed at a faster resolution of the housing crisis gain traction. Finally, a slower fiscal withdrawal than built in our forecast would help lift growth.

4. Against this background, the main policy challenge is to use effectively the limited policy space to support the recovery in the near term, while restoring fiscal sustainability with a balanced approach to medium-term consolidation and completing financial sector reforms. The recession significantly worsened the state of U.S. public finances, which were already on an unsustainable path, and exposed vast gaps in the financial regulatory and supervisory frameworks, which reforms are gradually addressing.

5. It is critical to remove the uncertainty created by the “fiscal cliff” as well as promptly raise the debt ceiling, pursuing a pace of deficit reduction that does not sap the economic recovery. The President’s February budget proposal envisages a reduction of the federal deficit of 3 percentage points of GDP for next fiscal year, from 8½ to about 5½ percent of GDP. But the implied reduction could be smaller, as the deficit for the current year will likely be below the budget projection (by about 1 percentage point of GDP). In staff’s view, even this smaller reduction would be too rapid, given the weak economy and downside risks, the limited room for monetary policy to offset the fiscal drag, and the risk that prolonged economic slack could reduce potential output through skill erosion and the exit from the labor market of discouraged workers. Staff’s recommended pace of adjustment would be consistent with a federal deficit of about 6¼ percent of GDP for FY2013—some ¾ percentage point of GDP higher than planned in the President’s budget proposal. This would imply a contraction of the general government structural primary deficit of around 1 percent of GDP in calendar year 2013. The composition of spending should be as growth-friendly as possible. In addition to infrastructure spending, training programs to limit skill mismatches and the risk of entrenching long-term unemployment, and housing initiatives (measures already proposed by the Administration), other potential measures include a further extension of emergency unemployment benefits. At the same time, promptly raising the debt ceiling would help reduce uncertainty and avoid the risk of losses in confidence and financial market instability as the deadline approaches.

6. At the same time, a comprehensive and credible fiscal consolidation plan is urgently needed. Policymakers should agree as early as possible on a comprehensive set of measures to stabilize the public debt ratio by mid-decade and subsequently put it firmly on a downward path. This would enhance room for fiscal policy maneuver in the near term, as well as limit the possibility of a future spike in risk premia on U.S. sovereign debt, which would be extremely damaging especially if it were to occur before the recovery became entrenched. To achieve this objective, policymakers could target a medium-term primary surplus of at least 1 percent of GDP, which would stabilize the debt ratio even factoring in a significant rebound of interest rates. In this context, the deep automatic spending cuts envisaged under the Budget Control Act (the so-called “sequester”) should be replaced with specific, back-loaded measures generating an equal amount of savings.

7. Given the size of the budget deficit, age-related spending pressures, and the relatively low tax ratio, this medium-term consolidation effort will need to rely both on higher revenues and reforms to slow the growth of entitlement spending.

• With discretionary spending capped and defense outlays projected to fall significantly, policymakers’ attention must shift to entitlements such as pension and health benefits, the key driver of spending growth. The cost-saving provisions of the health care reform should be implemented fully and additional saving measures could be phased in gradually. The Social Security imbalances warrant an early reform, including a modest increase in the retirement age, a more progressive benefit structure, and higher contributions.
• Revenues—which are low relative to GDP compared to other advanced economies—could be raised through a menu of options, including lower tax expenditures (which amount to some 7 percent of GDP and disproportionately benefit high-income taxpayers) the introduction of a VAT and carbon taxes, and higher marginal personal income tax rates. There is also room for improving the structure of corporate taxation, including by base-broadening, lowering marginal rates, and achieving a more efficient tax treatment of multinational enterprises.

8. Monetary policy conditions appropriately remain very accommodative, with room for further easing should the outlook deteriorate. We welcome the Federal Reserve’s recent decision to further extend the maturity of its securities holdings, which should keep downward pressure on long-term interest rates. The innovative tools adopted by the Fed over the past year have contributed to lowering yields on Treasury securities and maintaining a tight spread between agency MBS and Treasury bond yields. Should the outlook worsen, further easing may be considered. In this regard, given the relatively high share of the Fed’s holdings of Treasury securities at longer maturities and the importance of the housing sector for the outlook, additional net MBS purchases could be considered. Their effectiveness in supporting growth would be enhanced if policy actions and proposals to expand access to mortgage refinancing were to gain further traction. Easy monetary policy in the United States (as in other advanced economies) may encourage portfolio outflows, particularly to economies with favorable growth prospects and open capital accounts, potentially creating challenges for their macroeconomic management. However, these effects are likely tempered in the current unsettled external environment, characterized by high risk aversion and safe-haven flows to the United States. Furthermore, supporting U.S. growth would help strengthen the global economy at a particularly difficult juncture.

9. The current account deficit has declined after the crisis, but the external position remains weaker than justified by fundamentals and desired policies, implying a modest dollar overvaluation. In our baseline, the current account deficit is expected to widen modestly in the next few years as higher imports with strengthening domestic demand are partially offset by lower oil prices, leading to a further deterioration in the U.S. net international investment position. Over the medium term, fiscal consolidation aiming for a primary surplus of at least 1 percent of GDP accompanied by some depreciation of the dollar and adjustment in partner countries’ policies would allow for a strengthening of the current account balance of some 1–2 percent of GDP, consistent with external stability and full employment.

10. Staff welcomes the authorities’ renewed efforts to remove the distortions that prevent a faster resolution of the housing crisis. The authorities have responded to the persistent weakness in the housing market by enacting changes to their existing housing support programs—including the expansion of the mortgage modification and principal reduction program and the easing of some of the frictions in the refinancing program. Staff supports the timely and aggressive implementation of these measures, including the participation of the Government-Sponsored Enterprises in the principal reduction program. However, in light of the importance of the housing market in securing the economic recovery and the downside risks to the outlook, additional steps could be taken to strengthen the housing recovery. These include measures to facilitate the conversion of foreclosed properties into rental units and supporting access to refinancing on a larger scale, in line with the Administration’s proposals, which would also strengthen the positive impact of lower interest rates on aggregate demand. Consideration should also be given to allowing mortgages on principal residences to be modified in personal bankruptcy without secured creditors’ consent (cram-downs).

11. Policies are also needed to reduce the risk that long-term unemployment could morph into higher structural unemployment and reduce potential output. While staff views most of the increase in unemployment as reflecting cyclical factors, the long-term unemployment rate is significantly above levels seen in previous recessions and has declined relatively little since the start of the recovery. Elevated long-term unemployment raises the risk of a loss of human capital and attachment to the labor force, and could lead to a lower participation rate. Active labor market policies, such as training and support for job search, have been shown to improve the employment prospects of the long-term unemployed and thus should be adequately funded. Temporary tax incentives to expand labor demand—particularly if targeted toward the long-term unemployed—are also desirable.

12. There has been good progress over the past year in implementing the Dodd-Frank Act and global financial reforms, although more remains to be done to increase the resilience of the U.S. financial system. Progress included the introduction of enhanced capital standards under rules closely aligned with Basel 2.5 proposed for January 2013; the development of proposed rules to implement Basel III capital standards and strengthen other components of U.S. capital standards; the issuing of final rules on the submission of resolution plans (“living wills”) for systemically important financial institutions (SIFIs); the set up of the orderly liquidation authority; and the issuance of a final rule and interpretative guidance detailing a process and analytical framework for the designation of nonbank SIFIs for enhanced supervision and prudential standards. Also, the United States is among the jurisdictions that are closest to implementing new rules on centralized clearing of over-the-counter derivatives, in line with G-20 commitments. Areas where further progress is needed include:

• Regulation of the shadow banking system: Given the industry’s size, prominence in short-term funding markets, and susceptibility to runs, strengthening the regulation of Money Market Mutual Funds is critical, especially as the emergency backstop facility used during the financial crisis is no longer available. Options include the adoption of floating net asset values, capital requirements, and limits to redemption. Another important task is to reduce the systemic risk stemming from the dependence of the tri-party repo market on intraday liquidity provided by the clearing banks. Finally, the actual designation of nonbank SIFIs and finalization of the modalities for their enhanced supervision would also contribute to curbing systemic risk.
• Volcker rule. A ban on proprietary trading by banks should in principle reduce systemic risk. In drafting the final rule, regulators need to be mindful that its effectiveness could be hindered by exemptions and the migration of risky activities outside of the regulatory perimeter. At the same time, it is important to minimize the potential adverse spillovers of the rule on foreign entities and markets as well as market liquidity more generally.
• Housing finance: Removing the uncertainty related to the implementation of the risk-retention provision of the Dodd-Frank Act may help a gradual recovery of private securitization and ease mortgage market conditions. Also, there is a need to fully articulate a medium-term strategy to reduce the role of the GSEs, building on the 2011 White Paper, so as to encourage a gradual shift in the mortgage market towards private institutions. The reform must strike a delicate balance between providing an appropriate level of support to the housing market—with contingent liabilities explicitly recognized—and discouraging another cycle of overinvestment.
• Funding for regulatory agencies. Some agencies continue to experience budgetary constraints that limit their ability to meet the deadlines associated with the domestic and international reforms, and may hinder their ability to effectively monitor financial institutions and markets once the new regulations come into force. We view the lifting of these constraints as a high priority.

13. A multilateral approach to economic policy management remains critical for systemic countries such as the United States, whose policy actions have significant cross-border effects. In particular, the fiscal consolidation plan would be consistent with the rebalancing of global demand and reduction of global imbalances—together with efforts to increase domestic demand in surplus countries, as highlighted in the G-20 Mutual Assessment Process. At the same time, striking the right balance between fiscal consolidation and macroeconomic policy support would benefit the rest of the world, as it would avoid the risk of a spike in U.S. interest rates in the medium term and an abrupt decline in demand for economies with significant trade linkages with the United States in the near term. Given the size of cross-border financial linkages, further progress in implementing financial reforms coordinated with other jurisdictions in order to closely align key regulations and standards would be globally beneficial, and reduce the scope for regulatory arbitrage.

14. Staff welcomes the authorities’ continued commitment to trade liberalization and market access, in support of growth and expanded job opportunities. Staff noted the authorities’ intention to pursue opportunities for ambitious trade agreements in the context of the Trans-Pacific Partnership and with other trading partners, and encouraged them to develop fresh approaches to furthering negotiations on the multilateral trade agenda. Staff commends the authorities’ efforts to resist protectionist pressures in a challenging global environment, and to ensure continued consistency of domestic legislation and practices with WTO principles and international obligations.