U.S. Economy Returning to Growth, but With Pockets of Vulnerability

IMF Blog, June 4, 2015

Source details

Canonical URL: U.S. Economy Returning to Growth, but With Pockets of Vulnerability

Author: Christine Lagarde
Date: June 4, 2015
IMF staff completed their annual health check of the U.S. economy and a Financial Sector Assessment Program (FSAP) for the United States.
Focus of review: financial stability risks, policies to mitigate them, movements in the U.S. dollar, and the timing, form, and impact of interest rate normalization by the Federal Reserve.
A more detailed report on the U.S. economy and on the financial sector will be available on July 8.

Growth forecast for 2015 revised down to 2.5 percent, largely due to factors affecting the first quarter.
Labor market: job growth has averaged about 250,000 per month over the last year.
Near-term growth drivers:
- Cheaper oil prices expected to boost consumption in the remainder of 2015.
- Lower oil prices will continue to reduce oil-related investment, as observed in the first quarter.
Risks to the outlook:
- Further delay of the housing recovery.
- Strong dollar could drag on future growth despite recent improvement in the trade balance.
Medium-term and short-term growth expectations:
- Growth in the coming quarters is expected to be 3 percent or higher.
- Forecasts of potential growth are now around 2 percent (compared with over 3 percent average growth rates before the Great Recession).
Inflation outlook:
- Inflation pressures seen as muted due to long-term unemployment and high levels of part-time work indicating employment slack.
- Wage indicators have shown only tepid growth.
- With dollar appreciation and cheaper energy costs, inflation is expected to start rising later in the year, but only slowly, reaching the Federal Reserve’s 2 percent medium-term objective by mid 2017.

The Fed’s first rate increase in almost 9 years is being carefully prepared and telegraphed.
Risks of higher U.S. policy rates:
- Could result in significant market volatility with financial stability consequences beyond U.S. borders.
Recommendation on timing and path:
- There is a case for waiting to raise rates until there are more tangible signs of wage or price inflation than currently evident.
- Even after the first rate increase, a gradual rise in the federal funds rate will likely be appropriate.
- Such a path may create a modest and temporary rise of inflation above the Fed’s medium-term goal—perhaps up toward 2½ percent.
- A cautious and gradual approach to interest rate normalization would provide valuable insurance against the risk of disinflation and needing to cut rates back to zero.
Communication:
- Continued clear and effective communication by the Fed is critical in the coming months.
- Previous recommendations include scheduling press conferences after each FOMC meeting and publishing a quarterly monetary report; these merit consideration despite difficulties with adding more communication.

FSAP findings: Much has been done to strengthen the U.S. financial system; important to avoid rolling back legislative advances such as those in the Dodd Frank Act.
Current system condition: Data point toward a system with pockets of vulnerabilities rather than broad-based excesses.
Key concerns identified:
- Migration of intermediation to “shadow banks.”
- Potential for insufficient liquidity in a range of fixed income markets, particularly under stress.
The U.S. authorities are investing heavily in understanding and assessing these issues.

Give all individual Financial Stability Oversight Committee (FSOC) members an explicit financial stability mandate to strengthen FSOC effectiveness.
Undertake a concerted effort to provide the FSOC and the Office of Financial Research with the data they need to build a comprehensive view and analysis of systemic risks.
Update the regulatory regime in the insurance sector to create an independent and well-resourced body with a nationwide remit.

Given the forecast of a steady rise in the public-debt-to-GDP ratio, it remains critically important to adopt and implement a credible medium-term fiscal plan.
Required actions include:
- Tax reform.
- Social security reform.
- Steps to contain healthcare costs.
Fiscal consolidation would provide scope to expand the near-term budget envelope for growth-supporting measures.
Priority near-term public investment and policy actions:
- Infrastructure spending.
- Better education spending.
- Policies that raise labor force participation, including subsidized childcare assistance.

Near-term U.S. growth prospects are good.
It is better to wait for stronger signs of inflation pressures and have an interest rate hike in the first half of 2016.
Even after the initial rate increase, a gradual rise in the federal funds rate will likely be appropriate.
Although important progress has been made to strengthen the U.S. financial system, more work is needed to address pockets of vulnerability.

Source: IMF blog post "U.S. Economy Returning to Growth, but With Pockets of Vulnerability" (Christine Lagarde, June 4, 2015).