IMF Survey: Soft Landing Ahead for U.S. Economy

IMF News, August 6, 2007

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The U.S. economy should shake off the effects of a steep decline in the housing market and return to potential growth of almost 3 percent by the middle of 2008.
Housing investment, after exerting a substantial drag on overall growth in 2006 and 2007, should stabilize as its share in GDP is approaching historical norms.
Private consumption has remained strong despite the weaker housing market and high gasoline prices; it is expected to moderate a bit but supported by strong employment, continued income growth, and low inflation.
Business fixed investment, which slowed late last year after three years of solid growth, should recover with strong corporate balance sheets and continued profit growth.
Economic growth in the rest of the world should raise U.S. net exports.

Year-on-year growth is likely to remain for some time uncomfortably close to the 2 percent `stall speed' associated with past recessions.
Subprime mortgage difficulties could extend the housing downturn, which in turn could weaken consumption.
Financial conditions could tighten if lax underwriting standards uncovered in the subprime mortgage market prove more widespread and systemic.
With output still close to potential, unemployment low, commodity prices elevated, and productivity growth falling, cost pressures could boost inflation.
A turn in the credit cycle, especially if volatility and risk aversion rise, could expose financial vulnerabilities and unanticipated risk concentrations, with adverse effects on activity.
Events in recent days have shown increased market volatility and investor flight to safer securities, including U.S. Treasury obligations.

Current monetary policy is "consistent with a soft landing," and the Federal Reserve's Open Market Committee "has rightly emphasized maintaining well-anchored inflation expectations."
The Fall in the budget deficit tops expectations; entitlement spending is identified as a fiscal challenge.
The key fiscal challenge is "unsustainable entitlement programs" driven by rising health costs and aging.
Any reform of entitlement spending should be accompanied by tax reform; "Revenue increases may well be needed in addition to spending restraint" and "an overhaul of the complex tax system is in any case overdue."
A reduction in the current account deficit is needed; policies supporting U.S. savings, including further fiscal deficit reduction, would help that adjustment.
Staff analysis suggests that further dollar depreciation is required over time to rebalance demand and asset portfolios.
While the Fund agrees with the U.S. authorities' approach of focusing "prudential oversight on core institutions while relying on market discipline to limit risks in general," risk-taking and new instruments "have made it more difficult to assess vulnerabilities," emphasizing the need for supervisory systems geared to careful risk management.

The U.S. financial system accounts for about half of the world's private bond market and dominates the issuance of securitized assets.
Income of core institutions (commercial and investment banks) increasingly derives from bundling and servicing securitized assets for investors—asset-backed securities and collateralized debt/loan obligations (CDOs/CLOs)—rather than from holding loans.
The originate-to-distribute model has protected core institutions from credit risk, created peripheral institutions that contribute to market liquidity, and spread risk through asset-based securities.
Because originators do not hold loans on their own portfolios and remuneration is fee based, there is less incentive to maintain loan quality.
Many investors have grown complacent about credit quality and increased the share of higher-yielding, oftentimes more complex higher-risk securities in their portfolios.
At the time the report was completed in July, problems seemed mostly confined to the subprime mortgage market, but similar developments were noted in a few non-mortgage sectors such as leveraged buyouts.

U.S. growth prospects have important implications for the rest of the world; the degree of spillover hinges on conditions in U.S. financial markets.
To the extent that financial market distress of the sort associated with recessions is avoided, the impact on the rest of the world is much smaller—explaining the limited global impact of the U.S. slowdown so far.

IMF Survey online, August 6, 2007