Public Information Notice No. 02/81

Public Information Notice: IMF Concludes 2002 Article IV Consultation with the United States

August 5, 2002

On July 29, 2002, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with the United States.¹

Background

Following the longest U.S. expansion on record, the U.S. economy slipped into recession in early 2001, as industrial production dropped sharply, investment and exports declined, and employment and weekly hours fell.² The downturn was triggered in part by the collapse of the IT boom and stock prices in March 2000, but was further exacerbated by the September 11^th terrorist attacks, which contributed to a further plunge in confidence and job losses. As a result, following real GDP growth in excess of 4 percent during the previous four years, the economy slowed sharply in 2001.

However, growth turned positive in the fourth quarter of 2001 and accelerated strongly in the first quarter of 2002. The turnaround largely reflected a slower rate of inventory destocking and the remarkable resilience of consumption. Consumer spending was sustained by strong wage growth, the June 2001 tax cuts, lower interest rates, and special incentives offered by manufacturers. However, business fixed investment continued to decline through the first quarter of 2002.

Productivity growth remained unusually strong, surging in the fourth quarter of 2001 and first quarter of 2002. Unit labor costs fell and contributed to a turnaround in profits of the nonfinancial sector as measured in the national accounts. With the unemployment rate rising sharply from a 30-year low of just under 4 percent in 2000 to close to 6 percent in mid-2002, inflation pressures were subdued. Consumer price inflation eased to around 1 percent (12-month rate) by June 2002, with core inflation, as measured by the core personal consumption expenditure price index, near 1½ percent.

Despite the downturn, the external current account deficit remained at a high level, narrowing modestly from its recent peak of 4¼ percent of GDP in 2000 to 4 percent in 2001, then rising to 4¼ percent of GDP in the first quarter of 2002. Although imports of goods and services—particularly capital goods—fell sharply, the decline was offset by weaker exports, especially exports of high-technology goods and machinery. Net private capital inflows remained strong but eased somewhat in 2001, as a drop in net direct investment and equity inflows outweighed a pickup in foreign purchases of corporate and agency bonds.

In real effective terms, the dollar appreciated by over 20 percent during 2000 and 2001, strengthening against most major currencies. However, in early 2002 questions regarding the large current account deficit, the robustness of the recovery, the strength of corporate profitability, and accuracy of corporate accounting—especially in the wake of Enron's and WorldCom's failure—contributed to sharply weaker sentiment in stock and foreign exchange markets. As a result, the dollar weakened during March-July against most major currencies, including the euro, the Japanese yen, and the Canadian dollar. Equity prices, which had recovered the losses suffered in the aftermath of September 11, also fell sharply during this period, reaching levels not seen since 1997.

Monetary policy was eased aggressively during the course of 2001. The Federal Reserve lowered its target for the federal funds rate 11 times in 2001, including three 50 basis point cuts following the September 11 attacks, taking the federal funds rate to 1¾ percent by end-2001. The Federal Open Market Committee announced in March 2002 that the risks to inflation and growth had become balanced. During July 2002 testimony before Congress, Federal Reserve Chairman Greenspan indicated that, with little sign of inflation, there was time to wait before tightening monetary policy until "the forces inhibiting economic growth are dissipating enough to allow the strong fundamentals to show through more fully."

The federal fiscal position has weakened considerably since last year owing to the effects of the economic slowdown, the June 2001 tax cuts, increased security and defense-related outlays following the terrorist attacks, and the March 2002 stimulus package. Moreover, personal income tax revenues appear to have been considerably less than expected, mainly on account of lower capital gains realizations. The unified budget surplus declined from 2½ percent of GDP in FY 2000 to 1¼ percent of GDP in FY 2001, and a deficit of around 1½ percent of GDP appears likely in FY 2002.

The baseline projections that the staff had prepared at the time of the consultation discussions had envisaged a gradual acceleration of real GDP growth from 2½ percent in 2002 to about 3¼ percent in 2003. However, recent data releases and other developments, including the sharp decline in equity prices in recent weeks, have exacerbated the downside risks to the outlook for both personal consumption and business investment. The likelihood, therefore, is that downward revisions to the growth projections would be made in the context of the forthcoming World Economic Outlook.

Executive Board Assessment

Executive Directors noted the remarkable resilience of the U.S. economy during the past year, even in the face of the September 11 terrorist attacks. Although the economy fell into recession in early 2001—following the longest expansion on record—timely and forceful monetary and fiscal stimulus helped to spur recovery and contributed to the mildness of the downturn.

At the same time, however, Directors acknowledged that the turbulence in financial markets in recent months has significantly increased the uncertainties surrounding the outlook. Growth has already moderated from the rapid pace set in early 2002, but the recovery, although now likely to be weaker, is expected to be sustained as business investment rebounds, consumer spending continues at a solid pace, and productivity growth remains robust. However, the recent weakness of equity markets, which has been exacerbated by corporate accounting scandals, could pose a risk by undermining consumer and business confidence. Moreover, the underlying strength of corporate profits and investment still remains uncertain. Against this background, while the outlook is still broadly favorable, the downside risks have intensified.

Directors also reiterated concerns about the large U.S. current account deficit and the related imbalance in global growth performance. The widening of the U.S. current account deficit since the mid-1990s mainly reflects the effects of strong investment in the United States and capital inflows in response to superior U.S. productivity growth. Directors cautioned, however, that it seems unlikely that the U.S. net foreign liability position will continue to increase at present rates indefinitely. Therefore, most Directors suggested that the U.S. current account position would need to adjust at some point. The correction will preferably occur smoothly, as a result of improved growth performance in partner countries and a gradual shift in investor preferences. Directors stressed, however, the importance of policies that would support such an orderly adjustment, since abrupt reversals in investor confidence and capital flows and a sharp depreciation of the dollar would adversely affect U.S. investment and incomes and undermine recovery prospects abroad. They underscored the importance of boosting U.S. saving—particularly through disciplined macroeconomic policies—as well as of ensuring that risk management and transparency in the financial and corporate sectors are strong enough to cope with exchange market and other shocks.

Against this background, Directors urged the authorities to give priority in three policy areas—namely, disciplined fiscal policies; reforms of corporate governance and accounting; and strengthened U.S. leadership in trade and agricultural policies.

On the fiscal front, although Directors agreed that the fiscal stimulus of the last year had been timely, they expressed concern about the considerable deterioration in the medium term fiscal outlook. The economic slowdown, the June 2001 tax cuts, the additional outlays associated with the September 11 terrorist attacks, and the March 2002 stimulus package now mean that deficits are likely for the next few years. Although the Administration projects a return to surpluses on a unified basis after FY 2004, the federal budget will still be in deficit after excluding the surpluses of the Social Security system. Directors were concerned about the implication that fiscal policy will no longer be anchored by the earlier commitment to save the surpluses of the Social Security system.

Directors also cautioned that the Administration's medium-term projections may be optimistic. The budget assumes tight limits on discretionary spending, which may be difficult to realize, especially taking into account increases in defense and security-related outlays and in light of the apparent erosion of fiscal discipline in recent years. Tax revenues may also be weaker than expected, particularly given the shortfalls in the current year and the likely renewal of tax credits and relief from the individual Alternative Minimum Tax.

Directors considered that the fiscal outlook appears particularly worrisome against the background of the significant longer-run pressures on the fiscal system that will arise from the retirement of the baby-boom generation and the rapid growth of medical costs. As a result, the cash-flow positions of the Social Security and Medicare trust funds are projected to deteriorate later this decade, and to impose a growing fiscal burden thereafter.

As a first step toward addressing these longer-run pressures, Directors recommended establishing a fiscal framework with the clear goal of balancing the budget, excluding Social Security, over the business cycle. This objective would allow federal debt to be paid down in anticipation of reforms that would place the Social Security and Medicare systems on a sound financial footing, while also providing sufficient flexibility for fiscal policy to respond to cyclical shocks. A careful review of expenditure and tax priorities should provide the basis for realizing this medium-term objective.

Directors considered that the mechanisms under the Budget Enforcement Act have played a useful role in turning around the fiscal situation during the past decade. They encouraged the authorities to extend and tighten the rules under the Act, as this would signal the authorities' commitment to budget discipline and strengthen the credibility of the fiscal framework. Directors also supported the call to enhance budgetary transparency, and welcomed the Administration's willingness to participate in a fiscal Reports on the Observance of Standards and Codes. Directors stressed that steps still need to be taken to safeguard the long-term health of the Medicare and Social Security systems. Directors suggested that in the context of the objectives of the medium-term fiscal framework, revenue measures may also need to be considered. Preferably, these would be in the context of tax reforms that focus on base-broadening cuts in tax expenditures, and possible increases in energy taxes. Otherwise, nearly all Directors suggested that the pending reductions in marginal income taxes may also need to be reconsidered. A few Directors suggested a review of U.S. energy policy to reduce the economy's dependence on energy.

Directors welcomed the Federal Reserve's timely and skillful implementation of monetary policy over the last year. Given minimal signs of inflation pressures and the still considerable uncertainty regarding the economic outlook, Directors generally supported a continuation of the accommodative stance of monetary policy for the time being. Indeed, a number of Directors suggested that there is room for further easing if consumer and business confidence falters or if liquidity strains arise in financial markets. Directors noted that, as the recovery strengthens, continued support for the recovery will need to be carefully balanced against the possibility that delaying actions could require larger and more disruptive moves at a later date.

Directors observed that although credit quality had weakened during 2001, U.S. banks remain generally healthy despite the economic slowdown. In addition, although pressures could still arise owing to weaknesses in particular sectors, systemic risks appear relatively limited. Directors were also encouraged by the smooth functioning of the 1999 reform of the U.S. system of bank supervision, and they welcomed ongoing efforts to reform the deposit insurance system and to press ahead toward a new international capital accord. Some Directors encouraged the United States to undertake an Financial Sector Assessment Program. They also welcomed the redoubled efforts by the authorities to combat money laundering and the financing of terrorism in the aftermath of the September 11 attacks.

Directors reviewed recent events in the U.S. corporate sector, which have triggered valuable scrutiny of corporate governance and market discipline. They expressed concern that recent corporate failures and instances of accounting irregularities appear to have severely undermined confidence in the corporate sector and have contributed to a downturn in equity markets. Directors therefore welcomed the recent legislative and other initiatives to strengthen accounting and audit standards, corporate governance, and pension regulations. They stressed the importance of timely action in implementing these initiatives in a manner that enhances transparency and market discipline without unduly adding to regulatory burdens.

Directors took note of the important role played by the United States in global trade liberalization, and welcomed, in this context, the recent passage of trade promotion authority by the U.S. House of Representatives, which should clear the way for continued active U.S. leadership to maintain and strengthen open markets on a multilateral basis. They were concerned, however, that this leadership role and the broader support for multilateralism may be undermined by some recent U.S. actions. In particular, they pointed to the recent safeguard action against steel imports, which is likely to impose significant costs, both domestically and abroad, and could weaken confidence in WTO disciplines. Directors also agreed with the view that reforms in the area of contingent protection measures, such as anti-dumping filings, should be pursued to ensure that they do not discourage competition and trade, nor encourage similar actions by partner countries. Some Directors also welcomed actions to improve market access for developing countries, such as the African Growth and Opportunity Act.

Directors viewed the subsidies contained in the recent Farm Bill as damaging from a domestic and international perspective. The legislation has undermined the 1996 reform of agricultural programs that had sought to promote adjustment in the farm sector, and seems likely to encourage production of crops already in oversupply. As a result, it is likely to impose a significant cost on domestic taxpayers and also adversely affect producers abroad, especially from developing countries. Directors strongly encouraged the U.S. authorities to avoid allowing the Farm Bill to undermine multilateral efforts toward agricultural reform worldwide. However, they took note of the U.S. authorities' recent proposal to reduce agricultural subsidies in concert with other trading partners in the context of the Doha Round.

Directors welcomed the recent U.S. proposals to increase official development assistance (ODA) beginning in FY 2004, but remained concerned that these would still leave overall ODA spending as a share of GNP well below the U.N. target, and the lowest among industrial countries. A number of Directors called on the United States to increase further its ODA.

Directors noted that the quality, coverage, periodicity, and timeliness of U.S. economic data are considered to be excellent both in the context of the Article IV consultation and for purposes of ongoing surveillance. At the same time, however, Directors noted that there remains room for further improvement, especially in light of large statistical discrepancies in the national accounts, and encouraged further efforts in this area.