1. United States, Canada, and the World: Outlook and Challenges
- International Monetary Fund. Western Hemisphere Dept.
- Published Date:
- April 2012
After slowing in the second half of 2011, global growth is stabilizing. Policy action in Europe and better-than-anticipated U.S. economic performance have eased market strains and revived capital flows to emerging economies, although conditions remain volatile. Downside risks continue to dominate the outlook, given still-fragile public and financial sector balance sheets in many advanced economies. Nevertheless, the global environment under our baseline—easy financing conditions and high commodity prices—remains stimulative for much of Latin America.
Figure 1.1.Global activity has stabilized following a sharp deceleration in mid-2011. World growth is projected to slow and commodity prices to soften, but remain high.
Global Backdrop: A Quieting Storm?
Global growth softened during the second half of 2011, as uncertainties emerged about the strength of the U.S. recovery and the ability to contain the escalating crisis in Europe. European bank and sovereign spreads reached record highs, leading banks to curtail credit and countries to accelerate fiscal consolidation plans. Increased global risk aversion moderated capital flows to emerging economies, while fears of a sharp slowdown in emerging Asia pushed down commodity prices somewhat.
Since late 2011, better-than-anticipated U.S. data, along with strong policy actions in Europe (notably the European Central Bank’s Longer Term Refinancing Operation), have helped to turn market sentiment. Most European sovereign spreads have come down, equity prices have rebounded, and capital flows to emerging economies have picked up, although conditions remain volatile. Commodity prices have bounced back, particularly for oil, which is now close to historic highs amid growing Middle East tensions. Metals and food prices also are well above historic averages.
Figure 1.2.Global financial markets have rebounded and inflows to emerging economies strengthened since late-2011. But bouts of global volatility will likely continue.
Against this backdrop, global growth is projected to slow to 3½ percent in 2012, but return to 4 percent the following year. Downward revisions to the global forecast (½ percent relative to the September 2011 World Economic Outlook [IMF, 2011d]) reflect primarily the effect of lingering problems in Europe.1 The global expansion will remain uneven, led by emerging and developing countries.
Advanced economies are projected to grow by about 1¼ percent in 2012, after expanding by 1½ percent in 2011, as weak sovereign, financial, and household balance sheets continue to constrain growth. Europe is expected to register a mild recession, with drags from fiscal consolidation and further bank deleveraging. U.S. growth is projected to firm to slightly more than 2 percent annually during 2012–13, on the back of continued labor market improvements and a gradual housing-sector recovery.
Emerging economies as a whole are projected to expand by 5½–6 percent during the next two years, led by robust, albeit somewhat slower, growth in emerging Asia. Barring renewed turbulence, negative spillovers from the euro area recession are expected to be small (except in eastern Europe), partly offset by policy easing in some countries. In emerging Asia, growth will be increasingly driven by domestic demand, and current account surpluses will be moderate. With most emerging economies near full capacity, scope for further easing in the absence of a shock will be limited, and policies will need to aim at avoiding overheating and the buildup of financial excesses.
Commodity prices are projected to remain high during 2012–13, with energy prices above 2010–11 levels given geopolitical tensions and supply constraints. Although somewhat less than previous highs, owing to increased supply and more subdued demand from Asia, metal and food prices will remain at stimulative levels for commodity exporters.
Although risks to the near-term outlook abated somewhat in the first quarter of 2012, they remain tilted to the downside. The situation in Europe remains fragile, and fresh shocks to confidence could rekindle investor concerns and accelerate bank deleveraging with adverse impacts on real activity in Europe and beyond. In addition, rising tensions in the Middle East could set off a prolonged surge in oil prices, hitting global growth and metal and food prices.2
Significant downside risks are also likely in the medium term. Delays in enacting comprehensive fiscal consolidation plans in the United States (and other advanced economies) could eventually increase U.S. interest rates and the cost of financing globally. Meanwhile, difficulties in reorienting demand in China, away from investment and toward consumption, could result in an overinvestment cycle with an adverse impact on actual and potential growth. Weaker growth in Asia would reduce commodity prices, delivering a blow to commodity exporters.
Overall, a protracted process of balance sheet repair in advanced economies, although necessary, will likely hold back growth for an extended period. Given the appreciable economic slack, monetary policy in those economies is apt to remain accommodative for some time, leading to easy financing conditions in international markets. Fiscal consolidation will continue to restrain demand growth in advanced economies; at the same time, barring new shocks, strong fundamentals and balance sheets will underpin robust growth in emerging economies, keeping commodity prices high.
The United States: A Stronger, But Still Sluggish, Recovery
Following a sluggish first half, U.S. growth accelerated in the last two quarters of 2011, expanding at 2.4 percent (seasonally adjusted annual rate) as the impact of Japan’s earthquake unwound, inventories were rebuilt, and oil prices softened. Further signs of improvement have appeared since then. Private consumption remains resilient, as a steady recovery in jobs lifts income, and improving risk sentiment and robust profits bolster household stock-market wealth. After a dramatic contraction during the crisis, residential investment is now contributing to growth. Meanwhile, for the first time since 2008, the fiscal impulse was negative in 2011, due to strong revenues and lower-than-expected outlays amid delays in Congressional appropriations.
Labor and housing markets are recovering from depressed levels. Amid relatively robust job creation since the second half of 2011, the unemployment rate dropped to 8.2 percent in March 2012. However, long-term unemployment remains high, and there are concerns that the natural rate of unemployment could be rising (Box 1.1). Construction activity and home sales have expanded notably, albeit from a low base, but overall housing market conditions remain weak: elevated foreclosures and a large shadow inventory continue to weigh on house prices. Despite historically low mortgage rates and record high affordability, housing demand is held back by tight lending standards, still-elevated household liabilities, and subdued incomes.
Credit is reviving, except for housing, as banks are starting to ease lending standards and pricing from tight levels. Concerns about bank vulnerabilities have diminished on policy action in Europe and because U.S. banks reduced their exposure to the euro area (Box 1.2). Moreover, legal risks are down,3 and 18 of the 19 largest U.S. banks performed well in the stringent 2012 supervisory stress scenario undertaken by the U.S. Federal Reserve.
As a result of low core inflation, stable long-term inflation expectations, and a tepid recovery, the U.S. Federal Reserve continued to ease monetary policy, using a mix of conventional and unconventional measures aimed at driving down long-term interest rates. Notably, in January 2012, it extended by 18 months its earlier conditional commitment to maintaining extraordinarily low interest rates (now through mid-2014); and, for the first time, it revealed the Federal Fund rates projected by the members of its monetary committee. This step followed the Maturity Extension Program (or “Operation Twist”) of September 2011, aimed at increasing the maturity of its asset holdings.4 The ongoing operation has helped to hold down long-term interest rates.
As noted, fiscal policy turned contractionary in 2011. In 2012, the structural primary balance is projected to improve by an additional 1 percent of GDP—a broadly appropriate pace given the slow recovery. Nonetheless, the general government deficit, at about 9½ percent of GDP in 2011, remains one of the highest among major advanced economies, underscoring the challenges of fiscal consolidation in the medium term.
Under our baseline, the U.S. economy is projected to expand by slightly more than 2 percent in 2012–13, supported by gradually recovering housing markets, stronger household balance sheets, and steady job creation. However, growth will be constrained by fiscal restraint and subpar global demand.
Figure 1.3.U.S. growth is strengthening, but weaknesses in the housing sector continue to hold back the recovery.
Although strengthening labor markets present some upward potential, the U.S. outlook has significant downside risks in both the short and medium term. A worsening euro area crisis and a spike in oil prices caused by geopolitical factors are critical external risks.5 On the domestic front, house prices could post renewed declines (damaging household balance sheets, consumption, and employment); and an unduly large fiscal withdrawal could occur in 2013 amid political gridlock around the November 2012 elections. For the medium term, the absence of a comprehensive fiscal consolidation plan could lead to a sharp rise in interest rates.
With a still sizable output gap (about 5 percent of potential GDP at end-2011) and well-anchored inflation expectations, U.S. monetary policy should remain supportive of growth. Steps recently taken to strengthen communications and transparency should help enhance the effectiveness of monetary policy by improving control over long-term interest rates while keeping long-term inflation expectations well anchored. Should the outlook deteriorate, further monetary easing could be warranted.
In the near term, fiscal policy should be aimed at supporting the still-sluggish recovery. Given the unusual concentration of large tax provisions expiring at the end of 2012, and the risk of deep, automatic, and across-the-board spending cuts from 2013 onward, the fiscal stance in 2013 could be excessively contractionary. Reaching an agreement to avoid this outcome is crucial. In IMF staff’s view, the deficit reduction should proceed at a measured pace in 2013, especially in light of the weak economy and sizeable external risks.
Over the medium term, tangible progress in putting U.S. public finances on a sustainable trajectory is necessary. Early enactment of a comprehensive fiscal consolidation framework, with the deficit reduction proceeding gradually, should be a priority.
Both revenue-raising provisions and savings in core entitlements—such as health care and public pensions—will be necessary to put public finances on a sound footing (see Box 1.1 of the April 2011 Regional Economic Outlook: Western Hemisphere [IMF, 2011b]).
Figure 1.4.U.S. monetary policy will remain accommodative, while fiscal consolidation continues. Risk of a larger fiscal drag persists.
Further policy measures to support housing and labor markets also are needed. Actions to facilitate the housing market adjustment, including strong implementation of the administration’s recent proposals to ease mortgage writedowns and refinancing, would help accelerate the recovery. Strengthening active labor market policies, especially those aimed at helping the long-term unemployed through training and education, would also be important.
Finally, further progress in implementing the Dodd-Frank Act, including the “Volcker rule” (while paying attention to possible international spillovers), remains critical for improving the resilience of the U.S. financial system. Notwithstanding the creation of the inter-agency Financial Stability Council (FSOC), the U.S. regulatory architecture remains unduly complex, requiring strong coordination. Many specific provisions of the act have not been implemented owing to lengthy public consultation processes (which are taxing regulatory resources). Reform of housing finance also remains incomplete, given that the act leaves untouched the housing governments sponsored enterprises (GSEs).
Canada: Rebalancing Growth as the Fiscal Stimulus Fades
Economic growth in Canada slowed to 2½ percent in 2011, partly reflecting a gradual unwinding of fiscal stimulus and the continued burden from net exports. After a strong recovery from the 2008–09 crisis, the labor market is starting to weaken. The unemployment rate is edging up and real wages are stagnating, because of slowing job creation in the manufacturing and financial sectors.
Still, private investment, and to a lesser extent consumption, are expanding rapidly, supported by easy credit conditions for both firms and households. Household debt has reached record-high levels (more than 150 percent of disposable income at end-2011), supported by low interest rates and elevated house prices.6
During 2012–13, the Canadian economy is projected to expand by slightly more than 2 percent per year. Private domestic demand will remain the key driver of growth, while fiscal consolidation continues and export growth remains constrained by the tepid U.S. recovery and Europe’s challenges. With a strong Canadian dollar, the current account deficit is expected to decline only modestly in the medium term from its current level of about 3 percent of GDP, as the U.S. recovery gradually takes hold.
The main external risks come from the negative spillovers that renewed turmoil in Europe may have on U.S. economic activity and global funding conditions. On the upside, a faster-than-expected recovery in the United States and renewed stability in global financial markets would help lift exports and growth, including through their effect on commodity prices. A spike in oil prices would have a small, positive impact on growth in Canada, provided its negative effect on global growth is contained. Finally, elevated household debt and house prices persist as key downside risks on the domestic front. Private consumption could be weaker than projected as households feel the weight of elevated debt. The financial sector, which weathered the financial crisis well, would also be affected in a scenario with high households’ financial distress; although stress tests developed by the authorities indicate the losses would be manageable.
Canada’s key challenge is sustaining growth at close to potential against a backdrop of fiscal consolidation and unsettled global financial markets.
Figure 1.5.In Canada, growth is projected to moderate, reflecting in part high household debt and fiscal consolidation.
Current fiscal consolidation plans at the federal level are appropriately set and envisage a gradual fiscal withdrawal of ½ percent of GDP in 2012, and the achievement of a balanced budget by 2016. Although fiscal consolidation at the federal level remains necessary in the medium term, there is scope to adjust its pace if downside risks materialize. At the same time, however, provinces need to make further headway in their deficit-reduction plans. The federal government and the provinces will also need to undertake concerted efforts to deal with the longer term fiscal challenges posed by rising health costs in an aging society.
In light of existing economic slack and global risks, monetary policy will likely remain accommodative for some time, as long as inflation expectations remain well anchored. However, because a long period of low interest rates could lead to further leveraging by households, a further tightening of macroprudential measures may be warranted to curtail the expansion of mortgage credit—for example, larger down-payment requirements for new mortgages or tightening of debt service-to-income ratios.
Implications for Latin America and the Caribbean
Overall, the twin tailwinds of easy external finance and high commodity prices that have supported many economies in the region remain in place. Monetary policy in the United States and other advanced economies is likely to remain accommodative for some time; consequently, easy global financing conditions will continue, bringing the prospects of large capital flows into Latin America’s financially integrated economies, particularly those with strong policy frameworks. Commodity exporters (mostly in South America) will continue to benefit from favorable terms-of-trade, which in turn will drive domestic investment and foreign direct investment for some time.7
However, tourism- and remittances-dependent economies in Central America and the Caribbean will continue to face austere external conditions, as growth in advanced countries remains subdued and U.S. imports remain sluggish.
As noted, although downside risks have subsided in recent months, they still dominate the near-term outlook. The direct impact of a worsening European crisis on Latin America, however, may not be too large. Real linkages (trade and remittances) with Europe are relatively low, except in the Caribbean. Spillovers from European bank deleveraging also are likely to be limited; European banks have either limited presence in the region or, as in the case of Spanish banks, rely on profitable and well-capitalized domestically funded subsidiaries (see Box 2.1). Still, global repercussions from a tail event in Europe could have a more significant impact, through its effect on commodity prices, risk aversion, and capital flows (even short periods of financial stress could have adverse output on the region; see Chapter 3). Last, a spike in world oil prices could negatively affect nonoil commodity prices, hitting food and metal exporters.
Downside risks are expected to persist in the medium term. Notably, failure to put the U.S. public debt on a sustainable trajectory could eventually push up U.S. dollar interest rates. In addition, problems in effectively rebalancing China’s investment-led expansion toward consumption could result in a sharp growth slowdown, weighing down commodity prices and slowing world demand.
On balance, given the likelihood that the twin tailwinds will persist for a while, but not forever, countries in the region (especially in South America) should take advantage of the still-favorable external environment to strengthen their balance sheets, and avoid the buildup of vulnerabilities common in the context of abundant financing and high commodity prices. This will put them in a stronger position to respond to global shocks in the near term, as well as to smooth the transition to a less stimulative external environment in the medium term.
Figure 1.6.Growth in Central America and the Caribbean will be constrained by lower U.S. imports, but financial exposure and high commodity dependence makes South America more vulnerable to a global shock. Box 1.1.United States: Is the Labor Market Starting to Turn Around?
The U.S. labor market has improved during the last six months. The unemployment rate (8.2 percent in March 2012) has been on a downward trend since September 2011 (after hovering at 9 percent for the previous 2½ years), owing mainly to strong net job creation. An average of about 200,000 private jobs per month have been created since September 2011, compared with 84,000 during September 2009–11. Moreover, the percentage of adults who are working—another measure of the health of the labor market—has been rising in recent months, and is now at its highest level in almost two years.
The recovery has stretched across sectors and demographic groups. Education, health, and professional services have been the main job-creating sectors throughout the recovery, with manufacturing jobs also picking up more recently. The recent strengthening of job creation reflects a combination of temporary shocks (such as the fading off of supply disruptions from Japan’s March 2011 earthquake) and structural improvements, including diminishing job destruction by state and local governments and renewed job creation in the services sectors. Jobs are also gradually being created in the construction sector, as activity is beginning to firm up from depressed levels.
However, unemployment remains high, with an unusually large share of long-term unemployed. Almost 2½ years after the recession officially ended, almost 13 million people are still unemployed in the United States, 5½ million of them for more than six months. The long-term unemployed account for more than 40 percent of total unemployment (3½ percent of the labor force), about twice the previous historic peak, reached during the 1982 recession. In addition, income gains have been muted; and are projected to remain subdued because of slack in the labor market. Payrolls remain well below their pre-recession levels, but they are expected to start growing gradually because hours worked per worker are now near their pre-crisis peak.
Further improvements in the labor market hinge on the continued strengthening of household balance sheets. Growth remains sluggish compared with past recessions. Sustaining household consumption depends critically on the recovery of the housing sector, in which a large part of household wealth resides. Meanwhile, firms, which continue to sit on near-record profits, could accelerate hiring if the recovery is regarded to be less fragile.
The rise in the natural rate of unemployment (NAIRU) could constrain this recovery. Research suggests that the NAIRU has risen by at least 1 percentage point since the onset of the Great Recession, reflecting among other factors: (1) the uneven impact of the crisis across sectors (Barnichon and others, 2011) and (2) skill mismatches and difficulties in labor mobility attributable to a broken housing market (Estevão and Tsounta, 2011).1 The apparent increase in mismatches between available vacancies and the unemployed (suggested by the shifting out of the Beveridge curve) has coincided with high long-term unemployment. Long-term unemployed workers are less able to compete for jobs than workers who have just recently stopped working, because of skill erosion, lower connection to the workforce, and signaling (Krueger and Mueller, 2011).
Policies geared toward the specific needs of the long-term unemployed are necessary. With short-term and frictional unemployment rapidly approaching pre-recession levels, efforts should be geared toward the specific needs of the persistent and large pool of long-term unemployed. Training programs, including through community colleges, have been successful in other countries, as have tax incentives for hiring the long-term unemployed (Katz, 2010).
Figure: United States Labor Market Developments
Sources: Haver Analytics; and IMF staff calculations.
1 Seasonally adjusted data.
2 Short-term unemployment is defined as being unemployed for less than 27 weeks. Long term unemployment is defined as being unemployed for more than 27 weeks.
3 Recessions and expansions as defined by the NBER.
Box 1.2.United States: Financial Exposure to Europe
U.S. banks, money market mutual funds (MMMF), and insurance companies have limited direct claims on countries in the euro area periphery. These claims have declined substantially during the last year—by more than 25 and 90 percent, respectively, for U.S. banks and MMMFs (Table). Although potential gross derivative exposures and other credit commitments of U.S. banks are larger than direct claims, they likely overstate the true exposure of banks to the region.1 The recent debt restructuring in Greece did not cause noticeable disruption to U.S. banks.
The claims of the U.S. financial system on core euro area countries as well as the United Kingdom are larger, attesting to the central role played by financial institutions from those countries in global financial markets. With the intensification of financial turmoil in the euro area in the second half of 2011, pressures on U.S. financial institutions increased, widening spreads on credit default swaps (CDS) and depressing stock prices for large international banks, and outflows from MMMFs. In response, the substantial claims of U.S. MMMFs on core euro area banks have been scaled back by about half since June 2011, and their maturities are much shortened. U.S. banks tightened standards on loans to European banks and to nonfinancial firms with significant exposures to Europe. Since the beginning of the year, CDS spreads on U.S. banks have declined substantially (despite increasing more recently), and the retrenchment of U.S. MMMFs from the euro area has subsided.
The recently conducted “stress tests” on major U.S. banks indicate the resiliency of their capital structure to a very adverse global scenario, including financial turmoil in the euro area. The results of the Comprehensive Capital Analysis and Review of major U.S. banks, disclosed by the U.S. Federal Reserve on March 13, suggest that the capital adequacy of 18 of the 19 largest U.S. bank holding companies would be resilient to a very severe shock, including—for the six largest banks—a global market shock with additional stresses related to Europe. At the same time, the simulated shock only captures first-round effects, and does not incorporate banks’ creditors and counterparty responses to increased financial turmoil that could amplify the initial shock with adverse feed-back loops.
|Prime money market funds2|
Foreign claims and derivatives exposures. Latest: Sep. 2011.
Securities holdings of European issuers. Latest: Jan. 2012.
Exposures to European bonds.
Foreign claims and derivatives exposures. Latest: Sep. 2011.
Securities holdings of European issuers. Latest: Jan. 2012.
Exposures to European bonds.
In response to market pressure, core euro area banks have been reducing the scale of their international activities, but the impact on U.S. credit has not been noticeable so far. Although it is difficult to assess the net impact of core euro area banks’ deleveraging on credit extended in the United States, anecdotal evidence suggests that U.S. assets disposed of by European banks may have been acquired by U.S. banks. Also, the U.S. Senior Loan Officer Opinion Survey reports an expansion of U.S. banks’ business as a result of decreased competition from European banks, and it does not suggest that credit supply constraints are binding. Overall, the evidence suggests that the impact of deleveraging of international banks on U.S. credit has not been sizeable to date.Note: Prepared by Francesco Columba and Geoff Keim.1 These statistics do not account for the insurance purchased by U.S. banks against default in European countries; they do not adjust for the fact that credit commitments are typically not drawn entirely; and they assume no recovery value for assets and take collateral into account only if it is liquid and held outside the country of the obligor. The largest U.S. banks reported that the net overall exposures to the euro area periphery amounted to less than 1 percentage point of their assets as of September 2011, taking into account hedges and the value of collateral held against derivatives positions. That said, concentration of counterparty credit risk cannot be discarded.
Note: Prepared by Gustavo Adler, Luis Cubeddu, Eric Le Borgne, and Paulo Medas, with contributions from Francesco Colomba and Martin Sommer. Alejandro Carrion provided excellent assistance.
Despite recent policy action, bank deleveraging and fiscal consolidation in the euro area (especially in the periphery) are projected to be larger than anticipated last fall.
A settlement agreement was reached in February 2012 between the federal and state governments and five financial institutions accused of abuses of foreclosure and ancillary mortgage services. The settlement will provide up to US$25 billion in relief to distressed borrowers, and direct payments to federal and state governments.
The operation, which expires end-June 2012, entails the purchases of up to US$400 million of U.S. Treasury securities with remaining maturities of 6–30 years and the sales (of an equal amount) of U.S. Treasury securities with remaining maturities of 3 years or less. In addition, and to support conditions in mortgage markets, the U.S. Federal Reserve is reinvesting principal payments on agency debt and mortgage-backed securities (MBS) into agency MBS.
IMF staff estimate that a 10 percent increase in oil prices would reduce GDP growth in the United States by 0.15 percentage points. Gains in equity markets have largely offset the higher energy costs of recent months.
After some moderation in the second half of 2011, house prices in Canada gained renewed momentum in early 2012 (up 2.9 percent in February, month over month, seasonally adjusted). In addition, several house price indicators remain at historical highs (e.g., price-to-income and price-to-rent indices are 20–30 percent higher than the average of the previous 10 years).
Given limited prospects of a sustained run up in prices, the stimulus to growth from high commodity prices is projected to fade over time.