Mission Concluding Statement 

United States of America Concluding Statement of the 2021 Article IV Mission

July 1, 2021

A Remarkable Recovery

Tragically, the COVID-19 pandemic hit the United States hard. More than 600,000 Americans have died and average life expectancy has fallen. However, diligent work over the past year to develop vaccines and the rollout of vaccination programs over the past several months have begun to bring the pandemic under control. By mid-June, over one-half of the eligible population has been fully vaccinated and both new cases and the test positivity rate have fallen markedly.

The unprecedented fiscal and monetary support, combined with the receding COVID-19 case numbers, should provide a substantial boost to activity in the coming months. Savings will be drawn down, demand will return for in-person services, and depleted inventories will be rebuilt. Growth in 2021 is expected to be around 7 percent, the fastest pace in a generation, with modest risks to the upside. This strong economic performance should continue into 2022, with growth of around 5 percent. It is worth noting that these forecasts are based upon an assumption that the American Jobs Plan and American Families Plan will be legislated during the course of 2021 with a size and composition that is similar to that proposed by the administration. The U.S. external position is judged to be modestly weaker than the level implied by medium-term fundamentals and desirable policies.

Indicators suggest significant labor market slack remains which should serve as a safety valve to dampen underlying wage and price pressures. Inflation expectations are also expected to remain well-anchored. However, underlying inflation trends will be obscured in the coming months by significant, transitory movements in relative prices which could lead core personal consumption expenditure (PCE) inflation to temporarily peak later in the year at close to 4 percent. Once these temporary price realignments have passed through the system, PCE inflation is forecasted at around 2½ percent by end-2022.

United States: Selected Economic Indicators

Source: IMF staff forecasts

Fiscal Policies

The changes being proposed to federal tax and spending are aligned with past IMF policy advice. Multi‑year investments in power, transportation, telecommunications, and water will all help remove bottlenecks and increase productivity. There is solid empirical evidence also of the societal payoffs—in the form of lower poverty, better health and education outcomes, reduced crime, increased labor force participation, and better productivity—from providing high-quality childcare, creating a national paid family leave program, investing in pre-school, expanding access to college for low income students, increasing healthcare coverage, and improving college retention. Instituting a permanent increase in taxes on corporate profits and on high income households is warranted as a means to finance the permanent increase in spending obligations. Proposals helpfully include:

· A globally coordinated minimum corporate tax, applied on a country-by-country basis, which will be a crucial step forward in countering the incentives for profit shifting and base erosion.

· The elimination of loopholes that allow high income individuals to recharacterize labor income and escape tax on capital gains.

· A permanent expansion of the Earned Income Tax Credit to childless workers and an extension of the higher, refundable child tax credit which together will be instrumental in reducing poverty.

· Increased funding for the Internal Revenue Service which will have potentially large payoffs both in terms of revenues and in increasing the equity of the U.S. tax system.

It is worth highlighting that many of these tax and spending changes will directly support working mothers (who have long made up a large share of the poor and were hard hit by the pandemic ) and disproportionately help black and Hispanic families.

The size and ambition of the proposed fiscal packages is admirable. However, a better targeting of policies would further strengthen their impact on macroeconomic and distributional outcomes. Specifically, as the appropriations process moves ahead, more could be done to:

· Phase out tax credits at lower levels of household income.

· Prioritize spending toward programs that have the biggest impact on productivity, labor force participation, reducing poverty, and facilitating the shift to a low-carbon economy.

· Fully eliminate step-up basis, lower the threshold for paying the estate tax, eliminate the 199A passthrough deduction, and reformulate the business tax as a cashflow tax.

Reorienting the administration’s tax and spending proposals in this way would likely imply a slower (but more sustained) demand impulse, create a bigger boost to aggregate supply, and, in so doing, lessen the near-term risks posed by a sustained upswing in inflation. In this regard, the administration’s commitment not to raise taxes on households earning under US$400,000 per year represents an important constraint (98 percent of households are below this level of income). Without this limitation, further policy changes could be considered including:

· Increasing the U.S. reliance on indirect taxes by introducing a carbon tax and/or raising federal fuel taxes.

· Scaling back poorly targeted tax expenditures such as the income tax exemption for employer-provided health care, the capital gains tax exemptions for individuals selling their principal residence, and the deductibility of mortgage interest and state and local taxes.

· Aligning the combined (i.e., corporate plus personal) top statutory rate on capital income with the top marginal rate on labor income (which would imply taxing dividends and capital gains received by taxable entities at around 20–25 percent). Doing so would also help lessen the extent to which pass-through entities face a preferential tax rate.

Monetary Policy

The Federal Reserve’s actions have been highly effective both in the depths of the crisis and in supporting the recovery. While there were risks to introducing the new monetary framework in the midst of COVID-related uncertainty, the low neutral rate of interest and the asymmetries posed by the effective lower bound called for a new approach to policy. The Federal Reserve’s new policy framework has helped support a more rapid recovery from the pandemic and rightly commits to a near-term overshooting of the 2 percent longer-run inflation goal (in line with past IMF advice). Given the complexity of the U.S. economy and the uncertainties in implementing the new framework, it is appropriate to eschew closely parameterizing this new policy framework (e.g. by providing a formulaic time horizon over which inflation will be averaged or specific limits on the amount that inflation will be allowed to overshoot). Instead, the size and duration of the intended overshoot should be data dependent.

The combination of the new monetary policy framework and the economic boost from fiscal stimulus should be self-reinforcing. The flexible average inflation targeting helps increase the demand impact of the fiscal support by providing more accommodation. At the same time, the large fiscal boost increases the likelihood that inflation gathers enough momentum to sustainably exceed 2 percent (something that the U.S. and other advanced economies have struggled to achieve in the post-global financial crisis period).

In the coming months, the ongoing rapid pace of recovery and expectations of additional fiscal support will necessitate a shift in monetary policy. As discussed above, the reopening of the economy will create considerable unpredictability in PCE inflation during the next several months, making it very difficult to divine underlying inflationary trends. At the same time, presuming staff’s baseline outlook and fiscal policy assumptions are realized, policy rates would likely need to start rising in late-2022 or early-2023 (with asset purchases starting to be scaled back in the first half of 2022).

Managing this transition—from providing reassurance that monetary policy will continue to deliver powerful support to the economy to preparing for an eventual scaling back of asset purchases and a withdrawal of monetary accommodation—will require deft communications under a potentially tight timeline. Mitigating the risks of market misunderstandings, volatility in market pricing, and/or an unwarranted tightening of financial conditions (with all the negative spillovers to the global economy that such outcomes would entail) will require the Federal Open Market Committee to continue clearly telegraphing its interpretation of incoming data and articulating what those economic developments mean for policies. The Federal Reserve’s commitment—to communicate well in advance its thinking and to ensure that the eventual withdrawal of monetary accommodation is orderly, methodical, and transparent—is very welcome.

Risks to the Outlook

The principal risk facing the U.S. economy continues to emanate from the pandemic. The nature of the pandemic has changed globally, new variants are circulating widely, and there has been a shift in hospitalization and mortality toward younger Americans. Furthermore, while vaccines are widely available in the U.S., individual decisions on whether to take the vaccine have become a more binding constraint. Public health efforts in the U.S. will need to continue being applied rigorously, including by targeting populations where vaccination rates are low and by undertaking robust contingency planning to handle another surge of infections. Consideration should also be given to establishing a “standing army” for public health to create idle capacity in testing and medical supplies as well as build a rapid-response unit that could be deployed for testing, tracking, and treatment of viruses.

The U.S. has an important role to play in helping other countries contend with the public health crises, particularly in the developing world. This is not only for humanitarian reasons. Prompt international assistance—in the form of vaccines, medical supplies, and public health expertise—will pay dividends for the U.S. itself, lessening the COVID-19 risks ahead. In this regard, recent announcements by the administration of their intent to provide significant quantities of vaccines to other countries are highly commendable.

There are downside risks to the outlook from the potential that Congress will legislate a fiscal package that is smaller, or less comprehensive, than the one proposed by the administration. Staff forecasts anticipate an increase in discretionary spending and tax expenditures of US$4.3 trillion over the next decade which translates into a cumulative 5¼ percent increase in GDP during 2022–24. The fiscal plans will also have a meaningful, longer-run effect on aggregate supply. Approval of a smaller and/or less effective package of tax and spending would imply less of a boost to both supply and demand.

A surge in underlying inflation in the U.S. is not a likely outcome. However, it does represent an important risk to both the U.S. recovery and to global prospects. A slower rebound in labor force participation—due to public health concerns, retirements, incentive effects from unemployment benefits, or delays in reopening schools and childcare—could create a larger mismatch in the labor market and push wages and prices higher. Supply chain disruptions could prove to be more persistent. The demand impact of the fiscal stimulus could be larger and more front-loaded than currently assessed (especially given the accommodative monetary stance). The expected supply effects (e.g. on labor force participation, new capital formation, and productivity) could be smaller or slower to materialize. All these possibilities add to the risk that inflation expectations move upwards, creating self-fulfilling wage and price pressures.

In the event that these upside risks to inflation are realized, monetary policy will need to adapt quickly. If realized inflation moves higher but medium-term inflation expectations are well-anchored, the premium will be on communicating clearly that the changing environment calls for a withdrawal of monetary accommodation. However, the anchored inflation expectations will provide room for maneuver, allowing these policy adjustments to take place along an orderly timeline (i.e., similar to that already incorporated into staff’s baseline outlook). While this would imply a somewhat larger, more prolonged inflation overshoot, inflation should still return to the longer-run target relatively quickly. On the other hand, if there are unambiguous signs that inflation expectations have become de-anchored, monetary policy would quickly need to change tack, accelerating the reduction in asset purchases and even having to consider raising policy rates before net purchases have been brought to zero. This would likely create an abrupt shift in financial conditions and risk premia with negative implications at home and abroad. Clearly, it will be difficult to distinguish, in real time, between these two potential out-of-baseline risk scenarios, especially when there is substantial noise from the expected idiosyncratic and transitory shifts in a range of prices.

Spillovers

The impact on global activity from the rapid U.S. rebound is expected to be positive, particularly for Mexico and Canada. Although the Treasury yield curve has moved in anticipation of larger fiscal support, countries are generally benefiting from still-loose global financial conditions. Looking forward, some countries could face greater pressure in the coming months especially if dollar funding costs rise abruptly. This is particularly of concern for leveraged emerging market and developing economies with weak fundamentals, for commodity importers, and/or for those with an exchange rate pegged to the U.S. dollar.

Gaining From Trade

The administration has underscored the need for a “worker-centric” trade agenda that ensures that global trade benefits Americans as workers and wage-earners, not just as consumers. In pursuing these objectives, a removal of the obstacles to free trade would help support U.S. workers and create more and better U.S. jobs (particularly in light of the domestic efforts that are being proposed to increase productivity, labor supply, and the competitiveness of U.S. producers).

It is of significant concern, therefore, that many of the trade distortions introduced over the past four years remain in place. In particular, tariffs have been kept on imported steel and aluminum, washing machines, solar panels, as well as a range of goods imported from China. The administration has also committed to prioritizing U.S. producers in public procurement, strengthening “Buy American” requirements put in place by the previous administration. These policies should be reconsidered. Trade restrictions and tariff increases should be rolled back and “Buy American” provisions should be tightly circumscribed and made consistent with the U.S. international obligations. Doing so would underscore the U.S. traditional commitment to an open, stable, and transparent international trade regime.

The entanglement of trade and currency issues over the last four years—including investigations into currency-based countervailing duties on China and Vietnam and the inclusion of currency provisions in trade agreements—represents a significant risk to the multilateral trade and international monetary systems. Treating currency undervaluation as a subsidy to be countervailed raises concerns both in the finance and trade spheres and risks increased trade tensions and retaliation (with other countries replicating a similar approach, perhaps using their own standards and methodologies). Currency-related trade responses should be avoided. Enforceable provisions on currency policy should not be attached to U.S. trade agreements. Instead, the U.S. should work constructively with its trading partners to better address the underlying macro-structural distortions that are affecting external positions.

Finally, there is a clear need to address longstanding global trade and investment distortions in areas such as tariffs, farm subsidies, industrial subsidies, and services trade. The U.S. should work actively with international partners to strengthen the rules-based multilateral trading system and address these longstanding global trade and investment distortions. Renewed engagement at the World Trade Organization—including restoring the proper functioning of the dispute settlement system—could help facilitate progress on these topics.

Financial Stability Concerns

Systemic financial stability risks appear close to the historical average. However, the very accommodative financial conditions are encouraging continued risk taking and facilitating rising leverage in the nonbanks and corporates. The banking system appears to be in a strong position but leverage in nonbanks has increased and life insurance companies and hedge funds are exposed to lower-rated corporate debt. Fundamental shifts in the U.S. economy are increasing the risks associated with exposures to commercial real estate. There is, therefore, the potential for systemic problems to emerge from, or be propagated by, stresses in corporates or the nonbanks. These concerns are not lessened by recent episodes that highlight the incompleteness of the available information on nonbanks’ risk profile (including for family offices). In the absence of well-targeted macroprudential tools to manage such risks, consideration should be given to building larger buffers in the more regulated part of the financial system as a second-best substitute.

The housing market appears to be on a vigorous upward path which could raise financial stability concerns in the event of a reversal. Mortgage debt, though, has grown by a modest amount (around 5 percent year-on-year) and lending has been concentrated in households with high credit scores. Nonetheless, given the importance of housing for the broader economy, the buoyancy of the residential real estate market bears careful watching.

The unfolding pandemic revealed important shortcomings in the functioning-under-stress of systemically important U.S. markets and institutions (notably the Treasury market). Preventing a recurrence of those vulnerabilities that manifested in March 2020 will require a range of changes across markets and institutions. Possible changes that could be considered include central clearing of Treasury market transactions; the introduction of a standing repo facility to create greater certainty about the availability of market liquidity in times of stress; requiring retail prime and tax-exempt money market funds to move to a floating net asset value structure; subjecting funds to an annual liquidity stress test; and steps to require more liquidity protections from funds (e.g. more binding liquid asset requirements, pre-determined arrangements to lock-in a proportion of an investor’s shares, use of in-kind redemptions, swing pricing, and temporary gates on outflows).

The Challenge of Building Back Better

As the pandemic effects recede, policymakers will have to cope with simultaneous, ongoing transitions that include:

· A pandemic recovery that likely creates lasting shifts (in the U.S. and abroad) in consumer preferences and in the modalities by which the economy operates.

· A move to a low-carbon economy that will necessitate a significant reallocation of labor and capital (e.g. away from fossil fuels and heavy industry and toward renewables) and, potentially, a very different set of skills.

· A demographic transition whereby 22 percent of the population will be over-65 by 2040, the number of Americans over-85 will double by 2035, and the population will be increasingly racially diverse.

· Digitalization and other evolving technologies that will remake both production and consumption in unpredictable ways.

The longstanding flexibility and innovativeness of the U.S. system puts it in a good place to manage these transitions. However, great care should be taken to ensure that these multi-faceted changes do not increase income polarization, further hollow out the middle class, and leave behind a material share of the population (particularly lower-skilled, lower-income workers). It would be a mistake to assume the social and economic impact of these deep-rooted transitions can simply be left to market forces and the hope that a vibrant U.S. economy will lift all boats.

Instead, a multi-dimensional policy approach will need to be developed to support rising living standards for all Americans and prevent workers from becoming disenfranchised or detached from the labor force. A more effective social safety net and broader healthcare coverage will help. So too will increased investments in vocational and academic education. Greater spending on public investment can raise labor productivity and help improve living standards. However, other strategies may well be needed. These could include regional development initiatives to facilitate the transition. There may be a need to subsidize labor mobility (especially if newly created jobs are in areas where the cost of living and housing is higher). Efforts will be needed to ensure schools and colleges are equipped to provide students with the basic technical and critical thinking skills needed for a fast-changing economy. Also, immigration policies will need to be re-examined to ensure there is the right supply of skills needed to meet the demands of the newly created jobs.

A Greener Economy

The administration’s new impetus to reduce greenhouse gases represents a critical, and very positive, change of direction. While many of the steps that will be needed to achieve the administration’s climate goals have yet to be defined, the broad scope of the plans that have already been articulated (and the significant investments that are expected to be made), if realized, will jump-start the transition to a low carbon economy. However, it will be costly and difficult to achieve the administration’s climate objectives without a greater focus on carbon pricing. In particular, a new federal carbon tax would need to be an indispensable component of the administration’s climate strategy. Such a carbon tax could be combined with sectoral-based policies to tilt incentives away from carbon intensive activities. As political support is being built for a carbon tax, regulatory actions could be strengthened to increase disincentives for greenhouse gas emissions.

Announced efforts to reduce implicit subsidies for the fossil fuel industry are important. However, a similar approach is needed for the agro-industrial sector (which accounts for 10 percent of total U.S. emissions, approximately equal to the CO2-equivalent emissions of France and Italy combined). Policies in this area could include a phase-out of agricultural subsidies that incentivize high-emission farming activities, designing tax and subsidy schemes based on farm output and their relative emissions intensity, conditioning crop insurance subsidies to meeting benchmarks for reductions in greenhouse gas emissions, targeting support to fishing and marine farming practices that are compatible with marine biodiversity conservation, and researching lower-carbon agricultural practices.

A More Equitable Society

The U.S. has long faced high rates of poverty. Furthermore, the U.S. has long struggled with racial disparities in economic and social outcomes. Data suggests that minority households continue to be more likely to live in poorer neighborhoods, send their children to under-resourced schools, lack basic health care coverage, face lower socio-economic mobility, be more impacted by climate change, and be the victims of violent crime. The pandemic has worsened these disparities in outcomes, increased poverty, and added to wealth inequality.

The U.S. has important scope to strengthen its social safety nets and increase the progressivity of its tax system. Many of the administration’s proposed policies to mitigate poverty and increase social mobility have been argued for in past consultations. In addition to these proposals, greater attention could be paid to simplifying the multitude of federal, state, and local programs to aid the poor and to redesign social programs to remove “cliffs” (i.e., where programs phase-out abruptly as household income rises). To help ensure the benefits of federal tax credits and other assistance are incident on the working poor, there is scope to raise the federal minimum wage. Finally, it will be important for the administration to build into its policy design an increased focus on supporting those communities that have been historically underserved, marginalized, or adversely affected by persistent poverty.