Public Information Notice No. 97/16

Press Information Notice: The IMF Concludes Article IV Consultation with the United States

August 4, 1997

The IMF Executive Board on July 28, 1997 concluded the 1997 Article IV consultation¹ with the United States

Real GDP growth in the United States rose from 1.6 percent during 1995 to 3.3 percent during 1996, and reached an annualized rate of 4.9 percent in the first quarter of 1997. The rebound in growth over this period reflected broadly based strength in final domestic demand, led by business fixed investment and consumption. Growth slowed to 2.2 percent in the second quarter of 1997, as the pace of consumer spending eased substantially. The unemployment rate hovered between 5.2 and 5.4 percent from the second half of 1996 through early 1997, before falling below 5 percent on average during May-July 1997. At 4.8 percent in July 1997, the level of unemployment is well below most estimates of the natural rate. At the same time, there is little evidence of inflationary pressures. Excluding volatile food and energy prices, inflation measured by the consumer price index fell from 3 percent during 1995 to an annual rate of around 2 1/2 percent during 1996 and the first six months of 1997.

After a reduction in the target federal funds rate in January 1996, the stance of monetary policy remained unchanged during the rest of the year. At its regularly scheduled meeting in March 1997, the Federal Open Market Committee (FOMC) raised its target for the federal funds rate by 1/4 of a percentage point to 5 1/2 percent. In announcing this decision, the FOMC noted that, while evidence of a pickup in inflation was largely absent, monetary policy needed to be forward-looking if a low and stable inflation rate was to be maintained. With some evidence that output growth was slowing, the FOMC left the federal funds target rate unchanged at its meetings in May and July.

Fiscal policy actions and sustained economic growth have resulted in a steady decline in the unified federal budget deficit from $290 billion (4.7 percent of GDP) in FY 1992 to $107 billion (1.4 percent of GDP) in FY 1996. A decline in the structural deficit (i.e., the estimate of the deficit measured at full employment) accounted for most of the improvement in the fiscal balance, reflecting the effects of expenditure cuts and tax increases adopted in August 1993 as part of the Omnibus Budget Reconciliation Act of 1993 and subsequent actions. Economic developments in the current fiscal year have been more favorable than expected. In May 1997, it was estimated that the budget deficit would decline to about $67 billion (0.8 percent of GDP) in FY 1997, and more recent data suggest that the FY 1997 deficit may be even lower.

On a nominal effective basis, the value of the U.S. dollar increased by 4.4 percent during 1996, as the dollar continued to recover from its historic lows against the yen and deutsche mark in early 1995. The dollar's strength reflected relative cyclical conditions among major countries, as generally higher returns on dollar assets compared with those in other industrial economies attracted substantial capital inflows to the United States. The dollar appreciated further against other major currencies in 1997, with its nominal effective value rising by about 7 1/2 percent from December 1996 to July 1997. The external current account deficit rose from 2 percent of GDP in 1995 to 2.2 percent of GDP in 1996, reflecting the effects of the stronger dollar and robust growth in domestic demand on the merchandise trade deficit. The surplus in the capital account of the balance of payments rose sharply in 1996, as net private capital inflows increased with net foreign purchases of U.S. securities posting a strong increase and foreign official purchases of U.S. assets remaining at the very high level recorded in 1995.

Executive Board Assessment

Executive Directors congratulated the U.S. authorities on their skillful management of economic policies, which had yielded remarkable results, and noted in particular their success in bringing the economy to full employment while containing inflationary pressures. Directors discussed the possible factors underlying the exceptional performance of the economy; while this would require continuing further study, they mentioned the likely role of underlying improvements in long-term economic efficiency, reflecting the pervasive application of recent technological advances, and the flexibility of labor and product markets, as well as some temporary factors that had restrained inflation. Several Directors also noted that, in assessing the recent performance, account should also be taken of the uncertainties associated with problems in measuring output and prices. Directors considered that continued adept handling of monetary policy and further progress in reducing the budget deficit would establish a firm basis for sustaining the current economic expansion.

Directors noted that an immediate policy challenge was to guard against the emergence of inflationary pressures. In view of the high degree of resource utilization, the underlying strength of aggregate demand, and the likelihood that factors that have restrained inflation in the recent past--including slowly rising labor costs, the appreciation of the U.S. dollar, and increased external competition with weak growth in other major countries--would diminish in the period ahead, Directors agreed that the U.S. monetary authorities would need to remain vigilant.

Directors considered that a forward-looking approach to monetary policy was essential, given the lags with which monetary policy affected output and prices. Several Directors agreed with the authorities that there appeared to be no immediate need to tighten policy, given the present expected evolution of economic indicators. Those Directors, however, recognized that further interest rate increases could be required in the future if economic growth turned out to be stronger than expected. Many other Directors, however, cautioned that an undue delay in tightening monetary policy could undermine the current expansion by increasing the risk that aggregate demand pressures would build, and, from an international perspective, such a policy development could have disruptive effects on other countries, as more substantial increases in interest rates might be required subsequently to contain inflation. Those Directors took the view that a further, moderate, and preemptive tightening was necessary to guard against the emergence of inflationary pressures. Some Directors expressed the sense that, if stronger productivity growth had caused an upward shift in potential growth, this consideration would have important implications for assessments of the current stance of monetary policy. With regard to setting formal inflation targets, most Directors saw little need to change the current monetary policy approach, noting that the Federal Reserve's policies were already credible.

Directors considered that progress in reducing the budget deficit in recent years and the agreement between the Administration and the Congress to balance the budget by fiscal year 2002 had created a favorable medium-term outlook for U.S. fiscal policy. The remaining challenge was to implement and adhere to the terms of the agreement. In that context, some Directors urged the Administration and the Congress not to use prospects that revenue might be stronger than expected as a pretext to ease the terms of the agreement, and thereby lose a historic opportunity to bring the budget into balance on a structural basis. Many Directors also indicated that a faster pace of fiscal consolidation--by bringing forward spending cuts and delaying tax cuts--than that envisaged in the balanced budget agreement would help to contain demand pressures and enhance the plan's credibility, as well as increase the latitude for countercyclical fiscal policy. On the composition of fiscal adjustment, a few Directors expressed concern that the substantial cuts envisaged in discretionary spending might be difficult to implement given the substantial compression of such outlays in recent years, and the Administration's desire to raise spending on education and training, and they noted, therefore, that deeper reforms of the entitlement programs would have been desirable. While it was noted that discretionary defense spending was declining more rapidly than other nondefense-related discretionary expenditures, a few Directors, nonetheless, saw the need to reduce unproductive expenditures, including the reallocation of expenditures from defense to nondefense priority areas.

While the medium-term fiscal outlook was generally viewed as favorable, Directors cautioned that the aging of the U.S. population would place increasing strains on the Medicare and Social Security systems, with significant implications for fiscal policy over the longer term. Prompt efforts were required to reduce the financial burden that those programs would otherwise impose in order to avoid more draconian measures in the future. Directors supported the Administration's intention to establish a bipartisan commission to develop a plan to address Medicare's longer-term finances and encouraged the U.S. authorities to act quickly. While the financial problems of Social Security were less immediate, Directors nonetheless noted that a plan to shore up the system's longer-term financial position should be implemented as soon as possible.

Targeted tax incentives tended to narrow the tax base and make the income tax system less efficient and transparent. Directors encouraged the authorities to give consideration in the coming years to simplifying the income tax system and reducing distortions in order to enhance economic efficiency.

Over the past two years, the dollar's appreciation had helped to moderate aggregate demand and to limit inflationary pressures in the United States and had also helped to sustain growth in other countries. However, the strength of the U.S. economy relative to other major countries and the appreciation of the dollar was contributing to a widening in the external current account deficit, and the persistence of large U.S. current account deficits and growing international indebtedness would be a concern over the medium term. Directors noted that the best means of addressing that problem would be to boost national saving through continuing improvements in the fiscal position, with attendant benefits for both the United States and the world economy.

Directors welcomed U.S. initiatives to advance trade liberalization and encouraged the authorities to continue that effort. Directors also welcomed the preparedness of the United States to use the multilateral dispute-settlement procedures of the World Trade Organization for settlement of trade disputes. Directors urged the authorities to be cautious in their use of unilateral trade actions, and encouraged the United States to exercise its leadership role by pushing forward more quickly with trade liberalization in traditionally sensitive sectors, especially agricultural products and textiles.

Many Directors regretted the decline in U.S. official development assistance relative to GDP in recent years, and urged the authorities to reverse that trend. They also encouraged the authorities to meet their commitments to international financial institutions.

A few Directors also urged the United States, and other major countries, to work with the IMF to ensure that arms sales to developing and transition countries did not undermine efforts to strengthen macroeconomic policies in those countries.