United States
Staff Report for the 1999 Article IV Consultation

This 1999 Article IV Consultation highlights that the U.S. real GDP grew by 3.9 percent in 1998, reflecting buoyant consumption and investment spending. In the first quarter of 1999, real GDP grew by 4.3 percent (annual rate) before slowing to 2.3 percent in the second quarter. Consumption has been boosted by a sharp fall in personal saving, with the ratio of personal saving to personal disposable income declining to ½ percent in 1998, and turning negative in the first quarter of 1999.

Abstract

This 1999 Article IV Consultation highlights that the U.S. real GDP grew by 3.9 percent in 1998, reflecting buoyant consumption and investment spending. In the first quarter of 1999, real GDP grew by 4.3 percent (annual rate) before slowing to 2.3 percent in the second quarter. Consumption has been boosted by a sharp fall in personal saving, with the ratio of personal saving to personal disposable income declining to ½ percent in 1998, and turning negative in the first quarter of 1999.

I. Introduction1,2

1. The staff report for the previous Article IV consultation discussions was considered by the Executive Board on August 3, 1998 (EBM/98/85).3 Executive Directors noted at that time that the strength of the U.S. economy was facilitating adjustment in countries affected by the financial crisis in Asia and would help to continue to sustain growth in the world economy. With the U.S. economy estimated to be operating at a very high level of resource utilization, Directors considered that a key to successful policy would be to gauge the underlying strength of the economy so as to prevent the emergence of inflationary pressures. Although Directors believed that the stance of monetary policy was appropriate, they cautioned that labor market conditions were expected to remain tight and the influence of factors that had restrained inflation was likely to wane. Directors noted the rapid consolidation of the fiscal position in recent years and strongly supported efforts to preserve the budget surpluses in prospect over the medium term. Increasing strains would be placed on the fiscal situation as a result of the aging of the U.S. population, and Directors cautioned that prompt measures were needed to address the longer-term imbalances facing Medicare and Social Security. Directors welcomed U.S. efforts to promote trade liberalization and urged the authorities to strongly resist protectionist pressures that might arise as a result of the trade effects of the financial crisis in Asia.

II. Economic Developments and Outlook

2. Policy actions over the last six years have significantly improved the macroeconomic environment, helping to make the current economic expansion the second longest since World War II (Table 1).4 The unemployment rate has come down to its lowest level in decades without signs of inflationary pressure, in part because of significant advances in labor productivity growth and the rapid pace of investment. However, recent inflation restraint has also been aided by a number of factors that may be temporary, including an appreciation of the dollar and a decline in world commodity prices. Steadfast efforts to improve the fiscal outlook have helped to turn the unified federal budget balance to a surplus in FY 1998 for the first time in 30 years. And while continued global economic and financial market turbulence has slowed U.S. export growth, it has also stimulated a flight to quality that, together with significant fiscal consolidation, helped to lower long-term U.S. interest rates, thereby stimulating spending on consumer durables and business fixed investment.

Table 1

United States: Historical Economic Indicators

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Sources: U.S. Department of Commerce; and Board of Governors of the Federal Reserve System.

Contribution to GDP growth.

Private nonfarm business sector.

Business sector in chained 1992 dollar.

Monthly average on a unit labor cost basis (1990=100).

Yearly average.

On a NIPA basis.

Current surplus or deficit excluding net investment.

Gross national saving does not equal gross domestic investment and net foreign investment because of capital grants and statistical discrepancy. Net national saving and net private investment are expressed in percent of NNP.

3. The unflagging strength of the U.S. economy has helped to facilitate external adjustment in those countries most affected by financial market turbulence, and thus has been a major factor in helping to ameliorate world economic conditions. At the same time, personal saving has declined sharply in the United States, in part because of the financial wealth created by the surging U.S. stock market, and the external current account deficit has widened, raising concerns over whether imbalances might be emerging that could threaten the sustainability of the current expansion.

4. Despite the risks emanating from global economic and financial turbulence during 1998, the U.S. economy maintained its solid footing with real GDP increasing by 3.9 percent in 1998, and by 4.3 percent on an annual basis in the first quarter of 1999 (Figure 1). Buoyant consumption and investment spending acted as dual engines of growth, overcoming the considerable drag on the economy arising from a decline in the contribution of net exports (Figure 2). Personal consumption expenditures increased by nearly 5 percent in real terms in 1998, the largest annual gain in 14 years. Durable goods consumption was especially strong with real outlays rising by 10 percent. Although rising personal income, strong consumer confidence, and declining real interest rates all played a role in boosting consumption in 1998, the continued sharp increase in net household wealth fueled by the rise in equity prices (Figure 3) also underpinned its strength. Household saving as a share of personal disposable income declined to just ½ percent in 1998, its lowest level since World War II, and in the first quarter of 1999 turned negative for the first time ever.

Figure 1.
Figure 1.

United States: Real GDP and Domestic Demand

(Percentage change, same quarter previous year)

Citation: IMF Staff Country Reports 1999, 076; 10.5089/9781451839517.002.A001

Figure 2.
Figure 2.

United States: Consumption and Investment

(Percentage change, same quarter previous year)

Citation: IMF Staff Country Reports 1999, 076; 10.5089/9781451839517.002.A001

Figure 3.
Figure 3.

United States: Stock Market Developments

Citation: IMF Staff Country Reports 1999, 076; 10.5089/9781451839517.002.A001

5. Investment spending contributed 1½ percentage points to overall GDP growth in 1998. Falling mortgage interest rates helped to support an increase in real residential investment spending of over 10 percent. Real nonresidential business fixed investment was also remarkably robust, increasing by almost 12 percent on the strength of business confidence, robust profits, low interest rates, ready access to credit, and a sharp decline in computer prices.

6. Owing to strong domestic demand and the weakness in economic activity abroad, net exports subtracted just over 1 percentage point from overall growth in 1998, as the current account deficit surged to $221 billion (2½ percent of GDP) (Figure 4 and Table 2). This deterioration largely reflected a widening in the merchandise trade deficit, as import volumes grew by 10½percent while export volumes rose by 1½ percent. In addition, the balance on net investment income moved from a surplus of $3 billion in 1997 to a deficit of $12 billion in 1998. The international investment position of the United States deteriorated further, with the net foreign liability position rising to 18 percent of GDP.

Figure 4.
Figure 4.

United States: Current Account

Citation: IMF Staff Country Reports 1999, 076; 10.5089/9781451839517.002.A001

Table 2

United States: Balance of Payments

(In billions of dollars)

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Source: Bureau of Economic Analysis, U.S. Department of Commerce.

7. The steady improvement in government finances has helped to increase gross national saving as a share of GDP (Figure 5). After reaching a 50-year low of 14½ percent of GDP in 1992, national saving rose to about 17¼ percent in 1998. Net foreign investment in the United States rose from about ¾ percent of GDP in 1992 to 2½ percent of GDP in 1998, considerably above the average level of 1½ percent of GDP since the early 1980s. Gross domestic investment increased to 18¾ percent of GDP in 1998, from its low of 15¾ percent in 1991—real gross domestic investment as a share of real GDP is estimated to have increased to 20½ percent over this period. The strong investment is reflected in continued capital deepening.

Figure 5.
Figure 5.

United States: Trends in U.S. Saving

(In percent of GDP)

Citation: IMF Staff Country Reports 1999, 076; 10.5089/9781451839517.002.A001

8. For the third consecutive year, output growth in 1998 was well in excess of the staff’s revised estimate of potential GDP growth in the range of2½ to 2¾percent5 Strong employment growth helped to reduce the unemployment rate to its lowest level since 1970 (Figure 6). By June 1999, the unemployment rate had fallen to 4.3 percent, significantly below most estimates of the NAIRU (Figure 7).6 The share of the unemployed accounted for by those experiencing short spells of unemployment (less than 26 weeks) is near an all-time low. With the labor force participation rate broadly unchanged at 67 percent in 1998, the decline in the unemployment rate was led during most of this period by buoyant nonfarm employment growth.7 In contrast, weakness in the manufacturing sector associated with a decline in exports and an expansion in industrial capacity related to the domestic investment boom led to a decline in industrial capacity utilization from 83½ percent in December 1997 to about 80½ percent in April 1999—the lowest level since 1992.

Figure 6.
Figure 6.

United States: Employment Growth and the Unemployment Rate

Citation: IMF Staff Country Reports 1999, 076; 10.5089/9781451839517.002.A001

Figure 7.
Figure 7.

United States: Employment and Output Gaps

(In percent)

Citation: IMF Staff Country Reports 1999, 076; 10.5089/9781451839517.002.A001

1/ Actual less potential, as a percent of potential GDP.2/ NAIRU less actual unemployment rate.

9. Inflation has remained quiescent despite tight labor markets, largely reflecting the favorable impact of lower commodity prices, the strength of the U.S. dollar, and strong productivity growth (Figure 8). The annual rate of increase in the CPI edged down to 1.6 percent in 1998, but the core CPI (excluding food and energy) rose slightly to 2½ percent.8 The core PPI, however, increased by about 2½ percent in 1998 after having remained unchanged in 1997. With an acceleration in the growth of output per hour in the nonfarm business sector (rising to 2½ percent in 1998 from 1½ percent in 1997), unit labor costs increased by only 1½ percent in 1998. Despite the underlying moderation in nominal wage increases, the declining rate of CPI inflation helped real wages to rise in 1998 by just over 2 percent. In the first five months of 1999, the core CPI increased at an annual rate of 1.8 percent, while the core PPI was unchanged. Although certain indicators of inflation expectations (including the spread between inflation-indexed and nominal bonds) have risen somewhat in recent months, these remain low.

Figure 8.
Figure 8.

United States: Indicators of Inflation

(Percentage change, same period previous year)

Citation: IMF Staff Country Reports 1999, 076; 10.5089/9781451839517.002.A001

Inflation 1/

(Percentage change, December-over-December)

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Core inflation rates exclude changes in food and energy prices.

Fourth quarter over fourth quarter.

May 1999/December annualized for CPI, PPI, and average hourly earnings; 1999Q1/1998Q4 for employment cost index and unit labor costs.

10. The stance of monetary policy was unchanged during the first half of 1998. Thereafter, the Russian devaluation and unilateral debt restructuring in mid-August 1998 triggered a strong flight to quality and efforts by some financial institutions to unwind highly leveraged positions. This process resulted in a substantial decline in Treasury yields and a sharp rise in the risk premium on private debt. At the same time, commercial banks began to tighten credit standards, bid-ask spreads in many markets increased, the issuance of corporate debt slowed, and equity prices declined by almost 20 percent from their mid-July highs. Concerned that these developments might lead to a credit crunch and a sharp downturn in economic activity, the Federal Reserve eased monetary policy in three steps during September-November 1998, lowering the federal funds rate by a total of 75 basis points. Citing the potential for a buildup of inflationary pressures, the Federal Reserve announced following its regularly scheduled meeting in May 1999 that it had adopted a bias toward firming the stance of monetary policy in the period before the next meeting of the FOMC in late June. In the event, the FOMC raised its target federal funds rate by 25 basis points at its regularly scheduled meeting on June 30, 1999.

11. During the first half of 1998, short-term and long-term interest rates moved in narrow ranges just below 5¼ percent and just above 5½ percent, respectively. However, by late summer, as global financial turmoil intensified and investors sought safe and liquid assets, Treasury yields dropped sharply (Figure 9). The yield curve flattened further, with the spread between ten-year Treasury bonds and three-month Treasury bills narrowing to an average of just 7 basis points in September. The yield on three-month Treasury bills rebounded to about 4½ percent in November, and rose to 4¾ in June 1999, The yield on ten-year Treasury bonds increased to about 4¾ percent in December 1998, and then rose to almost 6 percent in June on concerns that the U.S. economy might be overheating. The broad monetary aggregates expanded rapidly in 1998, with M2 increasing by 8¾ percent (December over December) and M3 posting an 11 percent gain. This reflected, in part, ongoing innovations in money management, particularly by nonfinancial corporations.

Figure 9.
Figure 9.

United States: Interest Rates

(In percent)

Citation: IMF Staff Country Reports 1999, 076; 10.5089/9781451839517.002.A001

12. Following significant swings against other major currencies during the last year and a half, the dollar in real effective terms was only about 1 ¾ percent higher in May 1999 than in January 1998, although this was about 30 percent higher than its low in April 1995 (Figure 10). 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 (“yen-carry trades”) by financial institutions, and changing sentiment over the expected future strength of the dollar vis-à-vis the yen.9 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.

Figure 10.
Figure 10.

United States: Real Effective Exchange Rate 1/

(1990=100)

Citation: IMF Staff Country Reports 1999, 076; 10.5089/9781451839517.002.A001

1/ Based on unit labor costs.

13. 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 (Figure ll).10 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. The OBRA93 also extended budget enforcement provisions originally introduced in 1990, including caps on discretionary spending and a requirement that any changes to revenues or mandatory spending programs needed to provide their own financing (PAYGO), to help ensure that the deficit would not increase over a five-year period.11 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. The Administration estimates in its Mid-Session Review of the FY 2000 budget that on a current services basis, the FY 1999 budget surplus will rise to $99 billion (1,1 percent of GDP).12 The Congressional Budget Office estimated that the surplus would be even higher, at $120 billion. State and local governments increased their budget surpluses in 1998 to 1.7 percent of GDP (national accounts basis), reflecting the rapid growth in tax revenues and a slowdown in the rate of growth of transfer payments.

Figure 11.
Figure 11.

United States: Administration’s Budget Projections

(In percent of GDP; fiscal years)

Citation: IMF Staff Country Reports 1999, 076; 10.5089/9781451839517.002.A001

14. The staff projects that real GDP will grow by 3.9 percent in 1999, with growth slowing in the second half of the year to around its potential rate (Tables 3 and 4, and tabulation below). Consumption is expected to slow as households seek to rebuild their savings and the wealth effects of earlier stock market increases begin to taper off. Business investment spending is also projected to moderate in line with the slowdown in demand and growth, and somewhat higher interest rates will dampen residential investment. The economy is projected to grow in line with potential after 1999. The stance of monetary policy is assumed to adjust to help ensure that inflation does not rise above 2½percent over the forecast horizon. Although net exports are expected to be somewhat less of a drag on growth in 1999, the current account deficit is expected to widen to about 3½ percent of GDP before beginning to decline over the medium term, as domestic demand slows to a more sustainable pace in the United States and strengthens abroad.

Table 3

United States: Economic Outlook

(In percent changes from previous period, unless otherwise indicated)

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Source: Staff estimates for the World Economic Outlook.

Contribution to GDP growth.

Projections assume that the Administration’s FY2000 budget proposal as described in the June 1999 Mid-Session Review is adopted.

Table 4

United States: Indicators of Economic Performance

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Source: Staff estimates for the World Economic Outlook.

Data refer to unified Germany.

Composites for the country groups are averages of individual countries weighted by the average value of their respective GDPs converted using PPP weights over the preceding three years.

Includes statistical discrepancies.

15. There are, however, considerable uncertainties about this forecast So far, there are few signs of an autonomous slowdown in demand—which the staff and many other forecasters have been predicting for some time—and there are questions as to when, and to what degree, tight labor markets will begin to exert upward pressure on inflation. If growth in consumption and investment do not soon slow as expected, inflation may begin to rise and prompt further tightening of monetary policy. Given the relatively high stock market valuations, tighter monetary policy could act as a catalyst to a sharp market correction. In combination with the other channels through which monetary policy affects the economy, this could entail an overshooting of the intended effects of a monetary policy action and result in a more pronounced—at least in the short term—slowdown in U.S. growth. Alternatively, it is possible that economic activity abroad may be weaker than expected, in which case further downward pressure on U.S. net exports would add to the slowdown in GDP growth if consumption and investment slow as expected.

Staff Projections

(In percent)

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III. Policy Discussions

16. Against the backdrop of these recent developments, the following issues are central to the economic policy debate and were the main focus of the consultation discussions.

  • Key challenges are to assess: (i) whether conditions are in place that would slow the pace of economic activity in line with potential to avoid a reemergence of inflationary pressures in the absence of a monetary policy tightening; and (ii) whether potential economic imbalances (particularly the possible overvaluation of the stock market) raise significant risks of a “hard landing”.

  • With sustained federal budget surpluses in prospect under current policies, it will be important to resist pressures to increase spending and to cut taxes, particularly in the near term to avoid further stimulus to domestic demand

  • The rising share of the elderly in the U.S. population will place increasing strains on the Medicare and Social Security systems. Measures are needed to ensure that the fiscal surpluses in prospect over the medium term are used to address the longer-term financial problems of these two programs.

  • As growth in the rest of the world recovers, some reversal of safe-haven capital flows and some depreciation of the dollar can be expected, helping to narrow the U.S. external current account deficit. It will be important to maintain sound monetary and fiscal policies in order to mitigate the risk of a disorderly adjustment

  • Reflecting the past appreciation of the dollar and the weakness in domestic demand abroad, particularly in Asian markets, competition faced by U.S. producers has intensified leading to increased protectionist pressures, which should be strongly resisted

A. Economic Conditions and Prospects

17. During the discussions, the U.S. representatives indicated that the economy continued to benefit from a “virtuous cycle,” underpinned by sound fiscal and monetary policies. Subdued inflation, low interest rates, and rising equity prices were providing stimulus to consumption and investment, which, in turn, was generating strong employment and output growth that fed back again into income growth and stock prices. The pace of demand growth in the final quarter of 1998 and the first quarter of 1999 was clearly unsustainable, and was expected to begin slowing autonomously in the course of 1999. Such a scenario hinged on a continued negative contribution from net exports, moderation in consumer spending, especially through cutbacks in outlays for consumer durables, and some easing of investment spending. In view of the strength of the first quarter and the momentum that was expected to be carried into the second quarter, the U.S. representatives indicated that the growth rate for real GDP in 1999 had been revised up to about 3 to 3½ percent, which reflected a significant slowdown in the second half of the year. If the stock market remained buoyant, the U.S. representatives believed that the upper end of this range was the most likely outcome. Wage growth and employment costs were expected to remain subdued, although the recent pickup in oil prices would likely lead to some uptick in the yearly inflation rate in 1999.

18. The authorities and the staff agreed that the supply side of the economy had behaved differently than expected in recent years, as reflected in the continued underprediction of economic growth and the overprediction of inflation. A higher than usual degree of uncertainty surrounded estimates of the natural rate of unemployment and potential GDP, making these indicators less useful as guides to policy. Although recent estimates of the natural rate (typically in the range of 5 to 5¾ percent) had declined somewhat, the unemployment rate remained well below these estimates, and yet nominal wage pressures remained modest. Considerable capital deepening over the last several years, together with the benefits of adopting advanced technologies, had increased productivity growth. Officials’ estimate of the growth rate of potential output had been revised up to a range of 2½ to 3 percent. The U.S. representatives noted that this upward revision to potential GDP growth could be conservative. Although the authorities did not embrace the “new economic paradigm,” they noted that the continued strength of productivity growth and the failure of traditional models to forecast the sustained strong performance of the economy did suggest that some favorable structural changes were underway which had helped propel the “virtuous cycle.” Nevertheless, they emphasized, and the staff concurred, that while these changes made it more difficult to forecast the noninflationary limits of productive capacity, there was no doubt that such limits existed and they were determined not to be complacent in light of past policy successes.

19. The staff suggested that some imbalances had arisen in the U.S. economy that could present challenges for macroeconomic management and warranted close monitoring, particularly since they could be reversed suddenly. These included the unprecedented low level of personal saving, the sharply wider current account deficit, and indications that the U.S. equity market may be significantly overvalued, all of which were related (Figure 12 and Box 1). The U.S. officials noted that the widening of the current account deficit was, in part, attributable to the relative cyclical position of the United States vis-à-vis its trading partners in Europe and Japan, and would be at least partially corrected in due course with a restoration of a more evenly distributed pattern of world demand growth.

Figure 12.
Figure 12.

Selected Countries; Stock Market Indices

Citation: IMF Staff Country Reports 1999, 076; 10.5089/9781451839517.002.A001

1/ Nikkei 225, rebased Q4 1979 =100.2/ S&P500, rebased Ql 1989=100.3/ Sweden share price, rebased Q2 1988=100.

Stock Prices

In the past three years, concerns have grown that a speculative bubble was building in the U.S. stock market. Traditional indicators of stock market valuation have generally moved far out of line with historical norms. For instance, in the second quarter of 1999, the price/earnings (P/E) ratio for the S&P 500 stocks was 35, compared to a post-World War II average value of 17. For the P/E ratio to be sustained at its current, historically high level would suggest that investors may have developed unreasonable expectations as to the future growth of company earnings.

Since 1994, real earnings per share have grown at a 6 percent annual rate—far above historical trends and the growth rate of GDP. During the post-war period, real earnings growth has been in line with the growth rate of real GDP, reflecting the fact that the capital share of national income has been relatively stable over time. Using a basic model where the current stock price is specified as being equal to the present value of the future stream of dividend payments, the current P/E ratio would imply that investors expect real earnings to continue to grow by 6¼ percent a year, if it is assumed that the dividend payout ratio and the equity premium return to their historic averages of 50 percent and 4½ percentage points, respectively. If instead, expectations for real earnings growth were to move down in line with real output growth, then the current P/E ratio would suggest that investors were willing to accept an equity premium of only 1 percentage point Alternatively, if the equity premium were 6 percent (its average over the period 1985-94), then a P/E ratio of 35 would suggest that investors expect real earnings growth of 7¾ percent, which would require an unrealistic sustained increase in the share of corporate profits in GDP.

This analysis (and other indicators, such as the dividend/price ratio and Tobin’s q), suggests that stock prices may have moved significantly out of line with their fundamental determinants, but such a judgement cannot be made with a high degree of confidence. Investors’ expectations of high real earnings growth might be realized at least over the next few years as firms continue to experience gains in productivity (and profitability) associated with the adaptation of computer technology. It is also possible that the equilibrium equity premium has fallen. Innovations in financial markets have made it easier for individuals to hold diversified stock portfolios; the increased availability of self-directed, tax-deferred retirement accounts has increased the demand for stocks; and changes in tax treatment favoring capital gains also may have boosted demand for equities.

If a significant correction in stock prices were to take place, it would be expected to affect the economy principally through consumption, by adversely affecting consumer confidence and reducing household wealth. Traditional econometric estimates of consumption and savings behavior suggest that a one dollar rise in household wealth will boost consumption by 3-7 cents over a two-year period. Taking the midpoint of this range, a 25 percent drop in stock prices, for example, would reduce equity wealth by about $3 trillion and consumption by $150 billion (1¾ percent of GDP) after two years. However, the effect of such a decline in stock prices could be less than this estimate suggests, because it would return prices to roughly their levels of last year, and a portion of the increase in wealth since that time has probably not yet been reflected in consumption. Moreover, the staff’s estimates of savings behavior (see Box 2) which controls for the effects of improved household access to credit, suggest that such a correction in equity prices would have a significantly smaller effect on consumption. Investment also will be affected by a stock market decline, with significant indirect effects through business confidence. Equities, however, have not been a major source of funding for investment for the corporate sector as a whole; corporations have made large net repurchases of stocks in recent years, while significantly increasing their net debt.

A fall in stock prices might also affect the economy indirectly through the financial sector. While there is little direct financing of stock purchases in the United States through bank loans, rising personal wealth associated with the gains in the stock market could have facilitated access to credit, and default rates could well rise as equity prices fell.

20. The authorities observed that low personal saving and the current account imbalance were highly dependent on the sharp and sustained appreciation of U.S. equity markets (Box 2)13 National saving has risen in recent years, as corporate and government saving increased, more than offsetting the decline in personal saving. This decline was a rational response to rising net household wealth. The U.S. officials reasoned that buoyant investment spending was being driven by market-based opportunities and the overall strength of the economy. They saw no significant evidence of general or sector-specific overinvestment, although they were well aware that detecting such problems ex ante was difficult.

Explaining the Decline in the Personal Saving Rate

The rapid increase in consumer spending pushed the monthly personal saving rate into negative territory in late 1998 and early 1999 for the first time since monthly data have been collected. A declining personal saving rate, however, is not a new development in the U.S. economy. Personal saving began to decline in the early 1980s, with this trend continuing in the 1990s (figure below). Why might this decline be of concern? There are two possible reasons: (1) the effect on the sustainability of long-term growth; or (2) the risks for macroeconomic management associated with a sudden reversal in the saving rate. Concerns about long-term growth seem unwarranted, because gross national saving—the relevant factor in determining long-term growth—has recovered sharply in recent years. In contrast, the likelihood of a sudden reversal in the personal saving rate, with adverse effects on aggregate demand, depends on the nature of the factors which have contributed to its trend decline.

Staff analysis suggests that the trend decline in the personal saving rate during the 1990s is well explained by a rise in household equity wealth, tighter U.S. fiscal policy, improved access to credit, higher per capita Medicare transfers, and lower inflationary expectations—reflecting for example, the idea that less saving is needed to maintain the real value of non-indexed assets. The largest contributor to the decline in personal saving since 1990 has been the sharp increase in household equity wealth as a share of personal disposable income (see tabulation below). However, a significant decline in non-equity household wealth as a share of disposable income has had a partially offsetting effect. The shift in fiscal policy since 1994 has also been an important contributing factor, as higher government saving may be perceived to be associated with lower future tax liabilities (i.e., Ricardian equivalence). Lower inflationary expectations, together with higher Medicare transfers and improved household access to credit, account for the remainder. Of these factors, the one most likely to be subject to a sudden reversal—with implications for savings and aggregate demand—is the value of household equity holdings, in the event of a stock market correction.

Estimates of the Contribution of Long-Run Determinants to the Trend Personal Saving Rate (1990-98)1/

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Cumulative through mid-1998, and in percent of total decline in trend personal saving rate, based on econometric estimation (details are contained in the forthcoming selected issues paper).

A01sec3bx2ufig1

United States: Actual and Fitted Personal Saving Rate 1/

Citation: IMF Staff Country Reports 1999, 076; 10.5089/9781451839517.002.A001

1/ The fitted saving rats has been derived using HP filtered fundamentals.

21. The staff and the authorities agreed that the imbalances provided a strong additional reason to ensure that envisaged fiscal surpluses are realized Beyond this, however, it was not clear what macroeconomic policies could do, ex ante, to address these imbalances, even though eventual corrections might not occur smoothly. The prospects for sustained fiscal surpluses in coming years associated with efforts to shore up the longer-term finances of Social Security and Medicare should raise national saving and help to gradually ease pressures contributing to the relatively high external current account deficit. Indeed, the staff noted that there could be a case for a larger surplus in the near term, while demand growth was so strong, but accepted that this was not a politically feasible alternative.

22. There was also agreement that the possibility of a stock market correction posed the principal risk to the outlook in the near term, as the favorable economic environment may have induced investors to take on more risk and could be pushing asset prices to unsustainable levels. Officials observed, however, that although many of the traditional indicators had pointed to excessive stock valuations for some time, the market had proven to be quite resilient to a variety of shocks. Therefore, they suggested that one could not assert with a high degree of confidence that the market was overvalued. Even if such a judgement could be made, macroeconomic policy tools could not be finely calibrated to gently deflate a bubble. In the event of a significant stock market correction, the U.S. representatives did not envisage dire consequences for the economy, emphasizing that monetary policy would respond as necessary to promote continued noninflationary growth.14

23. The U. S. officials noted that there were no signs of general vulnerabilities in household and corporate balance sheets, a view which the staff shared, although it was recognized that problems could emerge in specific sectors in the event of an economic downturn (Box 3). Unlike equities, the U.S. real estate market did not appear to raise significant concerns of overvaluation, although there had been some general pickup in real estate prices recently and prices in some markets had recorded more sizeable increases (Figure 13). While household liabilities relative to disposable income had risen since 1992, debt-service payments had not increased commensurately because interest rates have fallen and households have refinanced mortgages at lower rates (Table 5).

Household and Corporate Balance Sheets

Is the sustained boom in consumption and investment contributing to balance sheet vulnerabilities that could cause problems in the event of an economic downturn or stock market correction? Aggregate data suggest that, while gross debt in relation to income has increased for both households and corporations during the 1990s, assets have grown even faster (even assuming some equity price correction) and debt-service ratios are not unduly high by historical standards. Of course, these aggregates can not indicate what vulnerabilities might emerge in specific sectors in the event of an economic downturn.

In the household sector:

  • With continued strong growth in consumer spending, household debt as a share of disposable income increased to about 104 percent in 1998 (Table). This increase reflected primarily the rise in mortgage debt as households have taken advantage of low mortgage rates to purchase homes, or to increase the size of existing mortgages, using the additional funds to retire other debts.

  • Lower interest rates have meant that despite the increase in debt levels, total interest payments as a share of disposable income have remained relatively flat at about 8 percent of personal disposable income (and the debt service ratio at about 17 percent). Because only about 15 percent of outstanding mortgages have adjustable rates, the shift toward mortgage debt has reduced the overall short-term vulnerability of household debt service to a rise in interest rates. Nevertheless, households would be vulnerable to a significant downturn in incomes associated with an economic slowdown.

  • With the rise in equity prices, household net worth as a share of disposable income has increased to 610 percent in 1998 from about 494 percent in 1990.

In the corporate sector:

  • The corporate debt-to-equity ratio declined to about 37 percent in 1998 from nearly 100 percent in the early 1990s, reflecting the surge in equity prices (Chart). If equity prices were to decline by 25 percent, this ratio would rise to about 49 percent, which is lower than the levels that persisted throughout the 1970s and 1980s.

  • The debt-to-income ratio increased in 1997-98, but remains well below the peaks reached in the 1980s.

  • Despite the increase in the level of debt, the debt-service burden has remained low as interest rates have fallen. Corporate debt service (measured as the ratio of net interest payments to cashflow) increased slightly in 1998 from its low of about 9 percent in 1997, but this is less than half the peak level reached in 1989. However, many financial and nonfmancial firms have increased their off balance sheet operations, making it harder to assess how the sector would be affected by higher interest rates or a fall in profit margins.

Balance Sheet of Households

(In percent of disposable income)

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Source: Board of Governors of the Federal Reserve System, Flow of Funds Accounts of the United States.
A01sec3bx3ufig2

Corporate Debt, 1969-98

(In percent)

Citation: IMF Staff Country Reports 1999, 076; 10.5089/9781451839517.002.A001

Figure 13.
Figure 13.

Selected Countries: Real Estate Prices

Citation: IMF Staff Country Reports 1999, 076; 10.5089/9781451839517.002.A001

1/ RebasedQ3 1979 = 100, land prices of six largest cities, residential areas.2/ RebasedQ2 1988 = 100, real estate prices of one and two dwelling buildings.3/ Rebased Ql 1989 = 100, price index of new one family houses sold.
Table 5

United States: Real Household Wealth

(In trillions of 1997 dollars) 1/

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Source: Board of Governors of the Federal Reserve System, Flow of Funds Accounts of the United States, Table B.100.

Deflated by the consumer price index.

Net worth equals total assets minus total liabilities.

B. Monetary Policy and the Exchange Rate

24. In view of the recent strength of aggregate demand growth, the staff suggested that if demand did not slow of its own accord, capacity limits would likely soon be reached and inflationary pressures would begin to emerge. The authorities agreed that recent demand growth had outstripped the growth in the economy’s productive capacity and that once capacity limits were reached, prices would certainly respond. However, they also pointed to the mixed signals being sent, as the rate of industrial capacity utilization had been falling over the last year while the unemployment rate hovered near a 30-year low. There were also indications that the economy had become less “inflation prone,” for several reasons. Businesses appeared to be operating in an environment in which price increases were frequently not viewed as a viable option, and thus cost-cutting measures were constantly being sought to maintain profitability. Technological innovations and expanding international trade linkages had helped to make supply more elastic, with firms able to respond quickly to eliminate incipient capacity bottlenecks. These factors suggested that once capacity limits were reached, domestic inflationary pressures would likely build more slowly than in the past, although they agreed that some of the transitory factors that helped to dampen inflation—notably low oil and nonfuel commodity prices—could well be reversed in the period ahead.

25. With this background, Federal Reserve officials emphasized that the Fed continued to be forward looking in the formulation of monetary policy. While the inability of traditional macroeconomic models to fit well with recent developments had made them reluctant to adjust monetary policy on the basis of forecasts alone, they were prepared to act promptly on the first indications that inflationary pressures might be in the pipeline. With less weight placed on model-based forecasts, the authorities focused on a wide array of early warning indicators of emerging inflation (including credit conditions, wages, salaries, and other employment costs, profit margins, the stock market, and the monetary aggregates), although no single indicator would play a decisive role in determining the course of policy. While the recovery in financial markets, viewed in isolation, might have suggested at least a partial reversal earlier in 1999 of the 75 basis point reduction in the target federal funds rate implemented in late 1998, the FOMC had not done so because there were no signs of sustained wage or price pressures at that time. The staff noted that given the significant lag between monetary policy actions and its effect on the real economy, there were risks in waiting too long for clear evidence of emerging inflationary pressures. Federal Reserve officials emphasized that decisions would continue to take into account the lags with which changes in the stance of monetary policy affect the real economy. Subsequent to the completion of the consultation discussions, the FOMC raised the target federal funds rate by 25 basis points in late June 1999.

26. In formulating monetary policy, the authorities sought to sustain high levels of employment, maximum sustainable growth, and low inflation. The longer-term objective has been to move gradually toward price stability over time, but officials cautioned that with inflation as low as it has been recently, it was not clear how much lower it should go. The staff and the authorities agreed that a zero rate of inflation could present potential difficulties (arising principally from nominal wage rigidities and a zero lower bound on the nominal interest rate). Federal Reserve representatives said that going forward their immediate goal would remain holding the line on the recent gains in lowering inflation.

27. Officials pointed out that in the formulation of monetary policy, international developments were taken into account only to the extent that they influenced U.S. domestic objectives. The external economic environment clearly affected the outlook for U.S. employment, growth, and inflation, and thus entered into the formulation of monetary policy. Conditions in international financial markets were also important in this regard, as turbulence in these markets would affect U.S. markets. Consequently, potential feedback effects needed to be carefully considered in the formulation of monetary policy. The financial turmoil following events in Russia last year, which had a direct impact on U.S. credit markets, was a recent example in which the U.S. policy response was domestically focused, but also took into account and helped to ease the financial tremors being felt around the world. The authorities noted, however, the difficulties in trying to predict the feedback effects through international capital markets stemming from a change in U.S. monetary policy.

28. The dollar’s strength has been supported by the cyclical position of the United States relative to its trading partners in Europe and Japan, as well as confidence in US. investment opportunities. The authorities noted that the size of the U.S. current account deficit should, and would, be reduced in due course with a realignment in world demand growth. The staff agreed and noted that the current account deficit would move to a sustainable level provided policies that ensured the maintenance of a strong fiscal position continued to be followed.15 The U.S. representatives observed that provided foreign investment was being employed productively in the United States, it would create the wherewithal to support future returns to foreign investors while also contributing to higher U.S. standards of living. Although the increasing stock of net foreign liabilities and the potential for shifts in investor sentiment suggested that adjustment in the exchange value of the dollar might not take place in a smooth manner, the staff and the authorities agreed that the continued implementation of sound macroeconomic policies would be the best safeguard against a disorderly adjustment. In the event that the dollar did experience a sharp and sudden realignment, the Federal Reserve, although not targeting the exchange rate, would be well positioned, if needed, to tighten monetary policy in order to limit the risk of a sustained inflationary effect.

C. Fiscal Policy

29. The current services baseline in the Administration’s Mid-Session Review of the FY 2000 Budget released in June 1999 envisages sustained fiscal surpluses over the medium term, rising from $99 billion (1.1 percent of GDP) in FY 1999 to $254 billion (2.3 percent of GDP) in FY 2004 (Figure 14 and Table 6).16 Adjusting the budget projections for differences in the staff’s and the Administration’s economic assumptions produces a somewhat more favorable profile for the current services balance, reflecting the staff’s higher real GDP growth and inflation projections that are only partly offset by the staff’s higher interest rate assumptions.17 For the current fiscal year, the U.S. representatives said that revenues were running somewhat ahead, and expenditures slightly behind projections in the Administration’s Budget presented in February 1999, and thus a modestly more favorable budget surplus for FY 1999 was likely; this has been borne out in the more recent data.18 The continued strength in economic activity underpinned the strength of revenues so far in FY 1999, and better-than-expected cost containment from the Medicare reforms enacted in the 1997 Balanced Budget Agreement appeared to be responsible for the lower-than-projected expenditures.

Figure 14.
Figure 14.

United States: Federal Budget Balance Projections

(In percent of GDP; fiscal years)

Citation: IMF Staff Country Reports 1999, 076; 10.5089/9781451839517.002.A001

Table 6

United States: Fiscal Indicators

(In percent of GDP, fiscal years)

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Sources: Budget of the United States Government: Fiscal Year 2000, Mid-Session Review (June 1999); and staff estimates. Staff estimates adjust the Administration projections for differences between the Administration and staff macroeconomic assumptions.

Excludes net interest outlays.

Debt held by the public includes debt held by the Federal Reserve Banks.

In view of the high degree of uncertainty in the present circumstances attached to estimates of potential GDP, for the purposes of calculating the structural balance, the staff assumed mat the output gap was closed in 1997, and will remain zero over the medium term.