Public Information Notice No. 99/70

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

August 5, 1999

On July 30, 1999, the Executive Board concluded the Article IV consultation with the United States.¹

Background

In the wake of the turbulence in domestic and world financial markets, the Federal Open Market Committee (FOMC) eased monetary policy in three steps during September-November 1998, lowering the target federal funds rate by a total of 75 basis points. Subsequently, in June 1999 the FOMC raised its target federal funds rate by 25 basis points.

The unified federal budget deficit has declined steadily since FY 1992, and it shifted to a surplus of ¾ percent of GDP in FY 1998. Expenditure cuts and tax increases adopted as part of the Omnibus Budget Reconciliation Act of 1993 (OBRA93) made lasting contributions to the improvement in the fiscal balance. Policy actions contained in the Balanced Budget Agreement of 1997 helped to ensure a further improvement in the unified budget balance in FY 1998 and beyond. Developments in FY 1999 have been favorable, and the federal budget surplus is expected to reach about 1¼ percent of GDP.

The dollar has been subject to significant swings in its value against other major currencies during the last year and a half. In May 1999, the real effective value of the dollar was only 1¾ percent higher than in January 1998, although this was about 30 percent higher than its low in April 1995. After appreciating by 5½ percent in the first eight months of 1998, the dollar on a real effective basis depreciated by about 7½ percent from August to December. The appreciation of the dollar in the first half of the year reflected the strong cyclical position of the U.S. economy relative to other major countries, as generally higher returns on dollar-denominated assets continued to attract substantial capital inflows. After peaking in mid-August, the dollar depreciated sharply against the Japanese yen largely reflecting the unwinding of extensive yen-short positions by financial institutions, and to changing sentiment over the expected future strength of the dollar vis-à-vis the yen. In the first five months of 1999, the dollar appreciated in real effective terms by 5½ percent largely reflecting a 12 percent nominal appreciation against the euro. The external current account deficit rose to $221 billion (about 2½ percent of GDP) in 1998, largely reflecting a widening in the merchandise trade deficit, as import volumes grew by 10½ percent while export volumes rose by 1½ percent. The international investment position of the United States deteriorated further, with the net foreign liability position rising to 18 percent of GDP.

Executive Board Assessment

Executive Directors commended the authorities for their sound fiscal and monetary policies, which together with the remarkable flexibility of the labor and product markets, had helped produce what is now approaching the longest economic expansion in U.S. history. This expansion, but primarily deliberate policy measures to improve the fiscal stance, had helped to turn the unified federal budget balance to a surplus in fiscal year 1998 for the first time in 30 years, and the outlook under current policies is for sustained structural budget surpluses over the longer term. Directors noted that during the recent period of global economic turbulence, the United States had been the principal engine of world growth, and its monetary policy had played a key role in stabilizing international financial markets. In the period ahead, however, Directors considered that the growth of demand would need to slow to a rate more in line with the economy's long-run productive potential. The policy challenge for both the United States and its international partners would be to restore a more sustainable pattern of demand growth in a nondisruptive manner.

Although the performance of the U.S. economy had been remarkable, Directors noted the contribution of possibly transitory factors and cautioned that there were significant risks. Principal among these is the danger of a substantial and abrupt decline in U.S. equity prices. Directors noted that the strength of demand, including corporate investment as well as household consumption, had been underpinned by the high level of stock prices-a level that was difficult to explain-and they were concerned that a sharp market decline could have significant effects on both domestic and foreign economies. Some Directors were particularly concerned that a decline in equity prices could lead to an abrupt adjustment in the household savings rate, which was now at a historic low. Others were less concerned because they considered that national savings, which had been increasing, was the more relevant concept.

Directors also noted that the sharp widening of the external current account deficit and the appreciation of the dollar had been important-but could not be permanent-factors in allowing rapid domestic demand growth without rekindling inflation. Further, Directors suggested that some other factors that had contributed to favorable wage and inflation performance in recent years, such as lower commodity prices, may also have transitory effects. Any abrupt reversal of these conditions could cause problems for macroeconomic management.

Directors considered that more than the usual uncertainty surrounded current estimates of potential output and the natural rate of unemployment, reducing the usefulness of these indicators as guides for macroeconomic policy. They recognized that strong investment and continued productivity gains had probably raised potential output more rapidly than in preceding periods, but agreed that it was difficult to gauge the respective contributions of underlying productivity performance and transitory factors. Regardless of these uncertainties, however, Directors cautioned that the economy still faced resource constraints, and the recent very strong growth in domestic demand could not be sustained for much longer without having inflationary consequences.

In these circumstances, many Directors considered that, unless there was evidence soon that the strength of demand growth was abating, the authorities should tighten monetary policy further to ensure that the expansion remained on a sustainable noninflationary path. Notwithstanding the inevitable uncertainties about the macroeconomic outlook, these Directors considered that the aforementioned risks to the economic outlook underscored the importance of acting promptly to keep inflationary pressures in check. They emphasized that waiting too long to act would risk having to raise interest rates more sharply later to stem a pickup in inflation, which would increase the likelihood of a sharp stock market correction and a "hard landing". Some other Directors, however, were less inclined to think that an increase in interest rates would be called for in the near future.

Directors strongly supported the Administration's intention to preserve a substantial portion of the federal budget surpluses in prospect over the medium term. For the near term, they emphasized the importance of resisting tax-cut and spending initiatives, which they saw as particularly inappropriate in view of the present strength of aggregate demand. For the longer term, preserving these surpluses would help the federal government address the currently unfunded liabilities associated with the aging of the population and allow early retirement of public debt. Directors considered that an appropriate longer-term fiscal objective would be to put the Social Security and Medicare programs on a sound long-term financial foundation, and to keep the remainder of the budget balanced on average over the business cycle. In this connection, they suggested that ongoing budget discipline could be facilitated by an extension, with appropriate modifications, of discretionary spending caps and the PAYGO financing requirement beyond their scheduled expiration in 2002.

Directors agreed that prompt measures were needed to address the longer-term imbalances facing Social Security and Medicare. They broadly supported the Administration's intention to maintain the basic structure of the Social Security system but also noted some concerns about the proposed use of general revenues to finance the Trust Fund. A number of Directors suggested that removing the link between outlays and Social Security payroll taxes could potentially erode an important constraint on unwarranted growth in Social Security benefits, and noted the significant contribution that changes in contribution rates and entitlements could make to placing the Social Security Trust Fund on a sustainable long-term footing.

Directors noted that, although the Administration's proposals on Medicare would extend the solvency of the system, they fall short of restoring the long-term financial viability of the system. Directors considered that periodic adjustments to the program were likely to be required because of the difficulties in projecting Medicare outlays. It would therefore be helpful to establish a mechanism for making adjustments in the program's parameters on a regular basis.

Directors noted that tax cuts proposed by the Administration in its fiscal year 2000 budget continued a tendency to use tax incentives to promote specific economic and social goals. While recognizing that such measures could in practice sometimes be the best available method of achieving such goals, Directors noted their potential to complicate the income tax system and increase compliance costs.

Directors agreed that the appreciation of the U.S. dollar over the past year and a half had shifted demand abroad, helping to avert overheating in the United States and mitigating the adverse effects of global economic turbulence. As growth outside the United States recovered, however, some reversal of safe-haven capital flows, and some exchange rate realignment was expected by Directors, which would help to narrow the relatively high U.S. external current account deficit. Directors considered that continued implementation of sound macroeconomic policies would increase the likelihood that any correction in the dollar's value would be orderly. In particular, they observed that the prospects for sustained fiscal surpluses in coming years should raise national saving and ease the pressures contributing to the widening external current account deficit.

Some Directors noted that indicators of banking sector vulnerability tend to be procyclical. They stressed the importance of continuing vigilance to ensure that supervisory arrangements remain strong in the face of potential vulnerabilities, and are able to cope with changes in the array of financial instruments and of the ongoing global integration of financial markets. Directors emphasized that the possible overvaluation in the major U.S. asset markets added to the need for such vigilance. Some Directors expressed special concern over the potential vulnerabilities of the financial system resulting from the activities of highly leveraged institutions.

Directors noted that the appreciation of the U.S. dollar and the weakness in foreign economies had heightened competition faced by U.S. import-competing producers and had stimulated a worrisome degree of protectionist sentiment, notably regarding trade in steel and agricultural products. Directors stressed that it was in the interest of both the United States and the international community to strongly resist these protectionist pressures. At the same time, they encouraged the U.S. authorities to continue to be a major force for the advancement of multilateral trade liberalization in order to foster a more hospitable global environment for trade. Directors also encouraged the United States and the authorities in other countries to continue to seek cooperative solutions in recent high-profile disputes, to refrain from resorting to restrictive trade measures, and to work together to improve the dispute settlement mechanism.

Directors expressed concern about the decline in U.S. official development assistance (ODA) as a ratio to GDP, and urged the authorities to raise the priority assigned to ODA and to re-establish the leadership role of the United States in this area, thereby helping to catalyze a resurgence in such assistance worldwide.

Directors noted that the quality, coverage, periodicity, and timeliness of U.S. economic data were considered to be excellent both in the context of the Article IV consultation and for purposes of ongoing surveillance.

Directors welcomed the authorities' decision to participate in the pilot project for the release of the Article IV consultation staff report.