Public Information Notice No. 06/82

Public Information Notice: IMF Executive Board Concludes 2006 Article IV Consultation with the United States

July 28, 2006

On July 24, 2006, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with the United States.¹

Background

The U.S. economy continued to grow strongly over the last year even in the face of a withdrawal of monetary stimulus and high oil prices. Household spending remained the principal driver of the expansion, spurred by mortgage borrowing and double-digit house price inflation. However, employment and wage growth remained modest, and the household saving ratio moved further into negative territory. As a result, and despite strong business saving and an improvement in the fiscal balance, the current account deficit reached a new record high.

Household consumption and residential investment have grown an average ½ percentage point faster than GDP since the 2001 recession, financed in large part through home equity withdrawal, stimulated by rapid house price inflation as well as innovative mortgage instruments, low refinancing costs, and easy access to tax-advantaged home equity loans. However, U.S. house prices now appear to be overvalued and with signs that market conditions are cooling, the housing market is no longer likely to provide significant support to household spending.

During the past year, business investment also remained robust, supported by declines in capital goods prices, the economic expansion, and high profits, even in the face of higher interest rates. U.S. businesses have generally used high profits and low interest rates to strengthen balance sheets and accumulate cash holding, suggesting that the fundamentals for investment remain strong.

With sustained strong growth and recent hikes in oil and commodity prices, resource utilization has increased and headline inflation remained high. Although core CPI inflation had been relatively subdued, in recent months the core rate has risen sharply, exceeding 2½ percent in June (12-month rate). At the same time, the unemployment rate-at just above 4½ percent in June-remains at the low end of most estimates of the NAIRU, and capacity utilization reached its long-run average. Nevertheless, unit labor costs have remained contained, reflecting solid productivity growth and modest wage gains.

The current account deficit has widened on higher oil prices and solid import demand, and stood at about 6½ percent of GDP in the first quarter of 2006. Nevertheless, the dollar remained broadly stable, and the U.S. net foreign liability position barely deteriorated in 2005, reflecting the valuation effects of the relative strength of foreign equity markets.

U.S. financial markets have provided important support to the expansion and facilitated the U.S. economy's ability to access foreign saving. Financial market innovation-including securitization and credit risk transfer techniques-contributed to low credit risk spreads and improved the pricing and allocation of credit risk. The increased activity of hedge funds has enhanced price discovery and liquidity in many of the new markets. At the same time, banks remained well-capitalized and highly profitable despite changing market conditions. While bank revenues continued to depend on the real estate market, widespread securitization has helped reduce vulnerabilities to regional shocks, and a range of indicators suggest that systemic risks are at a low ebb.

Against this background, the Federal Reserve Board continued to gradually withdraw monetary stimulus, raising the federal funds rate to 5 percent by the time of the Article IV discussions and further to 5¼ percent after the June 28-29 meeting of the Federal Market Open Committee (FOMC). On the fiscal front, federal tax revenues remained buoyant and expenditure discipline has been maintained, suggesting that the FY 2006 federal budget deficit is likely to outperform initial budget estimates and fall modestly to 2¼ percent of GDP. Looking forward, the Administration appears on track for achieving its goal of halving the federal budget deficit earlier than FY 2009.

The staff's baseline scenario for the short-term outlook is for a "soft landing," with growth easing to potential and inflation remaining contained. The housing market is likely to cool in response to high valuations and tightening financial conditions, reducing the impetus from consumption and residential investment, but strong fundamentals should continue to support business investment. The external deficit is likely to remain wide, but the drag on activity from net exports will lessen as growth abroad strengthens. On the supply side, solid productivity growth should accommodate wage gains while containing price pressures.

There appear to be competing risks to this outlook. The possibility of a more abrupt slowdown in the housing market, disappointments on the productivity front, and a disorderly adjustment to global imbalances, as well as the risk of higher oil prices more than offset the upside potential for business investment. Avian flu and geopolitical events represent further and more difficult to quantify downside risks. In contrast, inflation risks-which mainly stem from supply effects-seem mostly on the upside. These include the possibility of a larger-than-anticipated productivity slowdown pushing up unit labor costs, and the potential for pass-through of high commodity and oil prices.

Executive Board Assessment

Executive Directors agreed with the thrust of the staff appraisal. They noted that-despite a significant withdrawal of monetary stimulus, high energy prices, and other shocks-the U.S. economy continues to be a key engine of global growth, supported by strong productivity increases. Encouragingly, buoyant tax revenues are likely to keep the FY 2006 federal deficit well below initial budget estimates. Also, Directors commended the Federal Reserve for the measured pace of its monetary tightening which, accompanied by a clear communications policy, has helped keep inflationary expectations in check while avoiding a pronounced slowdown in activity.

Looking forward, Directors saw good prospects for a soft landing of the economy, with growth likely to ease to a more sustainable rate and inflation to remain contained. However, most Directors cautioned that risks to activity are on the downside, reflecting a cooling housing market, higher energy prices, and a negative household saving rate. At the same time, these Directors observed that the recent pick up in core inflation and expectations, coupled with a further drop in the unemployment rate, suggests a risk of a build up in price pressures.

Given these competing risks, Directors observed that the Federal Reserve will need to steer an especially delicate course that limits downside risks to activity while ensuring that inflation expectations remain anchored. In such circumstances, future policy decisions would depend heavily on evolving views on the outlook as well as the importance of ensuring that inflation expectations are kept in check.

Directors remarked that the Fed's communications strategy in recent years has been highly effective. Nonetheless, a number of Directors suggested that there could be merit in the Fed providing a more explicit statement of its inflation objective, noting that this could help further anchor inflation expectations without undermining confidence in the Fed's commitment to its broader mandate. In this context, some Directors remarked that a formal inflation target might bring little additional gain to the Fed's well-established credibility, while having implications for the Fed's other policy objectives. Directors looked forward to a further consideration of these issues, and welcomed the recent establishment of a committee to examine the Fed's overall communication policy, including refining the definition of price stability. Some Directors also observed that providing more frequent Monetary Policy Reports with a greater focus on future developments could further increase the Fed's high level of transparency.

Directors recognized that the U.S. financial sector has proven innovative and resilient in recent years, and noted that the financial system appears well-positioned as the credit cycle turns. At the same time, Directors saw important areas where further reform could help enhance the financial system's resilience and efficiency. These included tightening the supervision of the housing Government Sponsored Enterprises (GSEs), reforming rules for defined-benefit pension plan, and possibly moving to consolidate supervision and regulation of insurance companies. Directors welcomed the authorities' willingness to undertake an IMF Financial Sector Assessment Program, which they considered could provide further insights on these challenges, as well as a good framework for further analysis of the systemic role of the U.S. financial markets. It would be similarly beneficial to publish a regular Financial Stability Report.

Directors cautioned that demographic and other pressures continue to threaten long-term fiscal sustainability and economic prospects, especially given the need to accommodate the increased demands on public health and retirement systems from an aging population. They therefore welcomed the authorities' recognition of the importance of fiscal consolidation, including entitlement reform. With buoyant revenues supporting deficit reduction, most Directors suggested that the time is opportune to establish a more ambitious medium-term fiscal anchor. In particular, they noted that balancing the budget, excluding the Social Security surplus, within the next five years would set the federal debt ratio on a firm downward path. This would reduce the burden on future generations of providing health care and retirement income to the baby boom generation, while also providing the needed room to develop and phase in the reforms required to place entitlement systems on a more sustainable basis. It was observed that this would require consolidation of around ¾ percentage point of GDP a year. Such consolidation would provide a helpful boost to national saving and multilateral efforts to narrow global imbalances while having a manageable impact on U.S. and global demand. A few Directors cautioned that too rapid a fiscal consolidation could lower U.S. and global growth.

Several Directors observed that planned expenditure discipline may be difficult to sustain, especially in light of pressures to fund defense commitments and other emergency priorities. To help contain spending pressures, these Directors suggested there could be merit in re-introducing caps on discretionary outlays, as well as pay-as-you-go (PAYGO) requirements covering both entitlement spending and tax measures.

Although controlling outlays should remain central to deficit reduction, most Directors suggested that revenue measures should not be ruled out. They cautioned that it may be difficult to sustain the significant reductions in marginal tax rates of recent years while meeting the fiscal burden from population aging. They agreed that the priority should be on reforms that broaden the revenue base by reducing tax preferences, including those for mortgage interest payments, employers' contributions to health insurance plan premiums, and state and local tax payments, as suggested by the President's Advisory Panel. A number of Directors also agreed that consideration could be given to consumption-based indirect taxes-such as a national sales tax, a VAT, or energy taxation-that would maintain revenue buoyancy as workers retire.

Directors stressed the importance of re-invigorating the momentum for entitlement reform, and welcomed the proposed bipartisan commission to review this issue, which will be tasked with preparing proposals for reforming all three major entitlement programs to address future shortfalls. They noted that useful reform options have already been suggested-including for "progressive price indexation"-and that the key challenge now is to build the necessary consensus around a package of measures that would place the Social Security system on a more sustainable basis. However, concrete proposals will also be required to address Medicare and Medicaid funding gaps, especially given that with the addition of the new prescription drug benefit, the financial shortfall of the Medicare system dwarfs that of Social Security. While high-deductible health plans and other measures may help improve incentives, with health spending as a ratio-to-GDP well above the OECD average, Directors suggested that fundamental reform of the U.S. health care system would seem to be necessary.

At a more systemic level, and in light of the high U.S. current account deficit, Directors noted the risks in the medium term of a disorderly unwinding of global imbalances. While several Directors considered such risks to be relatively low, Directors agreed that the United States has a key role to play in supporting the cooperative strategy for an orderly resolution of global imbalances laid out by the International Monetary and Financial Committee in April 2006. In particular, they underscored the importance of boosting U.S. national saving, through ambitious fiscal consolidation, while also preserving the resilience and flexibility of the U.S. economy. Directors also generally considered that delaying the inevitable adjustment would mean continued increases in U.S. external indebtedness, and heighten the risk of a sharp disruption to exchange rates, financial markets, and growth-both domestically and abroad. In this context, they looked forward to the results of the multilateral consultations surveillance initiative, for the U.S. and other participating countries.

Directors agreed that leadership by the United States remains key to global trade liberalization, especially given the growing urgency of achieving an ambitious conclusion to the Doha Round negotiations. At the same time, most Directors cautioned that care would be needed to resist domestic protectionist sentiment and to ensure that bilateral trade initiatives complement rather than substitute multilateral approaches. While welcoming recent increases in U.S. overseas development assistance, Directors called on the authorities to boost such assistance further, noting that it remains one of the lowest among industrial countries as a proportion of gross national income.

¹ Under Article IV of the IMF's Articles of Agreement, the IMF holds bilateral discussions with members, usually every year. A staff team visits the country, collects economic and financial information, and discusses with officials the country's economic developments and policies. On return to headquarters, the staff prepares a report, which forms the basis for discussion by the Executive Board. At the conclusion of the discussion, the Managing Director, as Chairman of the Board, summarizes the views of Executive Directors, and this summary is transmitted to the country's authorities.