Public Information Notice No. 01/87

Public Information Notice: IMF Concludes 2001 Article IV Consultation with the United States

August 14, 2001

On July 27, 2001, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with the United States.¹

Background

Real GDP in 2000 grew by 4 percent—the fourth consecutive year of strong growth—but most of these gains were concentrated in the first half of the year, as growth slowed to an annual rate of around 1½ percent during the second half of 2000 and 1 percent in the first half of 2001.The slowdown in U.S. economic activity was more sudden than expected. Higher interest rates, rising energy prices, falling stock prices, and wider credit spreads contributed to reducing investment and dampening consumer spending. Lagging sales and a buildup in inventories triggered sharp cutbacks in production in some sectors of the economy and clouded corporate earnings and employment prospects, creating considerable uncertainty regarding the future course and strength of economic activity. Labor market conditions continued to be tight during 2000, with the unemployment rate hovering around 4 percent, but the situation eased in early 2001, and employment began to fall and the unemployment rate rose to 4½ percent by July 2001. Core inflation remained generally well contained; core consumer prices rose at around 2½ percent in 2000 and 3 percent in the first half of 2001, while the core deflator for personal consumption expenditures increased by about 2 percent in 2000 and 1¾ percent in the first half of 2001

The stance of monetary policy shifted in early 2001, as the Federal Open Market Committee (FOMC) responded to the changing balance of risks for inflation and output growth. With domestic demand growth outstripping the growth in potential output, the FOMC had raised the federal funds rate by a cumulative 175 basis points to 6½ percent over the period June 1999 to May 2000. As the slowdown in activity unexpectedly intensified in late 2000, however, the FOMC indicated in mid-December that weakening economic activity had become a more significant risk, and then surprised markets in early January 2001 when it lowered the federal funds rate by 50 basis points in advance of its scheduled meeting. Subsequently, in the first six months of 2001, the Federal Reserve cut rates on five more occasions—which included an intermeeting cut in April—bringing the federal funds rate down to 3¾ percent.

The unified federal budget balance recorded a surplus for the third consecutive year in FY 2000, with the surplus rising to 2½ percent of GDP, from 1¼ percent of GDP in FY 1999. The steady improvement in the fiscal balance since the early 1990s reflects in part the strong growth performance of the U.S. economy, as well as fiscal legislation enacted since 1993, mainly the Omnibus Budget Reconciliation Act of 1993 and the Balanced Budget Act of 1997. In FY 2000, federal debt held by the public declined to 35 percent of GDP.

In real effective terms, the dollar appreciated by 5 percent in 2000 and by a further 4½ percent in the first five months of 2001. A 5 percent depreciation of the dollar against the yen in 2000 was more than offset by a 15¾ percent appreciation against the euro. During the first seven months of 2001, the dollar appreciated by 11 percent against the yen and by 4¼ percent against the euro. In real effective terms, the dollar in May 2001 was 40 percent higher than its low in April-July 1995. The external current account deficit widened to about 4½ percent of GDP in 2000, from 3½ percent in 1999, largely owing to a widening in the merchandise trade deficit, as an increase in import volume growth from already high levels more than offset a substantial increase in export volume growth driven by a strengthening of economic activity in partner countries.

Executive Board Assessment

Executive Directors commended the U.S. authorities for implementing sound fiscal and monetary policies over the past decade which provided a strong foundation for the longest U.S. economic expansion on record. Economic activity slowed, however, more sharply than expected in late 2000 and in the first half of 2001, reflecting the effects of rising energy prices, falling stock prices, a drop in business and consumer confidence, higher interest rates, and squeezed profit margins. The ensuing slowdown in the rest of the world has further dampened economic activity in the United States. Directors expressed concern that, in light of the importance of the U.S. economy to the rest of the world, any prolonged weakness in the United States was likely to be felt elsewhere, and especially in those economies that are highly dependent on the United States for exports.

Directors agreed that at the present juncture, the uncertainty surrounding the economic outlook was higher than usual. Whether economic activity picks up in the second half of 2001 or remains sluggish for an extended period depends on a number of interrelated factors, including how consumer and business confidence evolve and affect spending, and whether the rapid rate of underlying productivity growth seen in the second half of the 1990s is sustained.

In these circumstances, Directors welcomed the flexible policy stance that the authorities have been pursuing in recent months. They considered that the principal policy priority is to revive near-term growth and welcomed recent actions on the monetary and fiscal fronts as appropriate and timely. They commended the Federal Reserve's aggressive easing of monetary policy since the beginning of 2001. Most Directors expected that inflationary pressures would remain generally quiescent, and therefore should provide the room for monetary policy to support economic activity in the event of persistent weakness. However, a few Directors warned that the authorities should remain vigilant in monitoring inflation prospects. Whether further easing will be needed will depend on the economy's response to past interest rate cuts, with additional cuts needed if economic and financial indicators remain weak.

Directors observed that judgments about whether domestic and external financial imbalances in the U.S. economy would be resolved in an orderly manner depended importantly on prospects for underlying productivity growth. These prospects would play a crucial role in determining whether the favorable economic performance of the late 1990s could be resumed and inflation pressures remain contained. The deterioration in the external current account balance to a large extent had been driven by the surge in U.S. productivity growth during the second half of the 1990s which had boosted the relative return on capital and attracted substantial capital inflows to the United States. Although evidence suggests a reasonably favorable outlook for underlying productivity growth—reflecting continued gains in technological innovation and in the adoption and diffusion of technology—Directors cautioned that less optimistic productivity prospects could trigger a less favorable outcome and pose a significant challenge for U.S. policy.

Directors indicated that the size of the U.S. external current account deficit did not appear sustainable in the longer term and that it raised concerns that the dollar might be at risk for a sharp depreciation, particularly if productivity performance proved disappointing. A sudden correction in the current account deficit was seen as possibly having adverse effects on the United States and the rest of the world economy. Directors stressed that disciplined macroeconomic policies-including continued fiscal surpluses-would help to facilitate an orderly adjustment in the dollar and the current account deficit. At the same time, they observed that further reforms in other major countries, that would enhance prospects for profitable domestic investment, would also help to ensure that the adjustment of global external imbalances takes place in a manner conducive to strong growth in the world economy.

Directors expressed concern about the decline in personal saving and rise in household and corporate debt levels in recent years. They cautioned that if productivity growth turned out to be far weaker than the growth rates experienced since the mid-1990s, the economic slowdown could be prolonged, adversely affecting household and business balance sheets. At the same time, given that the rise in equity wealth in recent years had contributed to the decline in household saving, Directors noted that a further decline in equity prices could depress consumption and raise the personal saving rate in the short term, pushing the economy into a more pronounced decline. Although in these circumstances supportive monetary policy could cushion the negative impact, a sizable adjustment in household and corporate balance sheets would need to take place to reduce debt levels.

With the current weakness in economic activity, Directors viewed the recently enacted tax cut, which will help to insure against a sharper economic slowdown, as appropriate and timely. However, they emphasized that, more generally, fiscal policy should remain focused on the medium term, with decisions about tax policy reflecting structural considerations. They agreed that the reduction in marginal personal tax rates would create better incentives to work and invest, to improve transparency, and to lower compliance costs.

Directors cautioned that the total cost of the tax cut was likely to be higher than current estimates suggest unless offsetting actions are taken, largely owing to the likelihood that tax measures would not expire as scheduled. They saw expenditure slippages as a significant risk, particularly in light of the tendency in recent years for discretionary spending to rise faster than mandated spending limits. Given the uncertainties about the final costs of the tax cut, the ability to contain discretionary spending, and the accuracy of fiscal forecasts, Directors recommended that spending increases and multi-year tax cuts should be implemented flexibly so as to ensure that there will be sufficient resources over the medium term to finance these measures.

Over the longer term, Directors considered that a reasonable fiscal target would be to set aside sufficient resources to put Social Security and Medicare on a financially sound footing and keep the rest of the budget in balance over the economic cycle. They urged that at this point priority be given to strengthening the financial outlook for Social Security and Medicare, particularly because at present there are sufficient resources available to address these problems. Preserving the surpluses in the Social Security and Medicare Hospital Insurance trust funds and balancing the rest of the budget would constitute a meaningful first step in achieving this fiscal target. Directors noted that additional reform efforts would be needed for both Social Security and Medicare and would best be implemented sooner, rather than later, to avoid the need for more drastic measures if reforms were unduly delayed.

Determined fiscal policy efforts over the last decade have dramatically improved prospects for paying down the U.S. government debt, and overall budget surpluses in the period ahead are expected to exceed the government's redeemable debt. After that, one possible approach to manage the build up of assets would be to establish individually controlled voluntary personal retirement accounts within the Social Security system, while another approach would be to invest these balances through the Social Security trust fund. Regardless of the means chosen, Directors underscored the need to set aside sufficient resources to finance the future liabilities of Social Security and Medicare.

Directors observed that the overall condition of the U.S. banking sector remains healthy, although banks had seen some deterioration in loan quality in 2000 and the first half of 2001. In this connection, they cautioned against the risks associated with the use of off-balance sheet instruments. Directors expected that the slowdown in economic activity will likely result in some further deterioration in credit quality and bank profitability. However, currently high profit and capitalization levels are expected to cushion the impact of these negative developments, allowing banks to weather the economic slowdown without undue difficulties.

Directors considered that, in light of the importance of the United States as a global capital market and recent legislation in the financial area, it would be useful if the United States participated in a Financial Sector Assessment Program. Directors called on the staff to report on U.S. policies with respect to anti-money laundering in future Article IV consultations and in a separate report to the Board some time soon.

Directors urged the United States to continue to push for further liberalization of international trade on a multilateral basis and that efforts to initiate a new round of multilateral trade negotiations should remain a key priority. Although the African Growth and Opportunity Act and the Caribbean Basin Enhanced Initiative improved market access for developing countries in these regions, they encouraged the authorities to take additional steps to improve duty- and quota-free access to the U.S. market for these countries and to provide such access for all countries, particularly the least-developed countries.

Directors cautioned that the recent continued strength of the U.S. dollar and the slowdown in U.S. economic activity could give rise to a greater frequency of calls for trade protection, noting in particular the recent safeguard action initiated on behalf of the steel industry. They urged that the authorities resist such pressures for protection. In addition, to promote market competition and limit the use of antidumping (AD) and countervailing duty (CVD) actions, Directors suggested that the authorities change the manner in which AD/CVD procedures are administered so that such protection is provided only in those cases where foreign producers are found to be engaged in anticompetitive behavior.

Although Directors acknowledged that U.S. agricultural support is lower than in many other OECD countries, they noted that in recent years supplemental assistance to U.S. farmers has created distortions in the farm sector, which may have contributed to reducing world prices for major grains and oil seeds, adversely affecting producers in other countries. Directors urged the authorities to resist pressures to continue such supplemental agricultural assistance and to return to the goals of the Federal Agriculture Improvement and Reform (FAIR) Act implemented in 1996, which was designed to move government assistance to the farm sector away from price supports and toward income supports.

Directors expressed concern about the continued low level of U.S. official development assistance as a ratio of GNP, and urged that the authorities increase their commitment to foreign assistance to bring it in line with the U.N. target of 0.7 percent. However, Directors welcomed U.S. support for the enhanced HIPC Initiative.

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.