United States
2001 Article IV Consultation-Staff Report; Staff Statement; and Public Information Notice on the Executive Board Discussion
Author: International Monetary Fund
Publication Date:
14 Aug 2001
eISBN:
9781451839531
Language:
English
Keywords:
ISCR; CR; monetary policy; price; Greenspan; federal funds rate; fiscal policy; business sector; productivity growth; potential GDP; economic expansion
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Sound fiscal and monetary policies have provided a strong foundation for the longest U.S. economic expansion on record. Executive Directors agreed that the U.S. economy strength had been supported by rising real income, enhanced profitability, and rising household wealth. Directors cautioned the need to reduce the domestic demand growth, and maintain monetary and fiscal policies. Directors expressed concern about the decline in personal saving, rise in household and corporate debt levels, and supported preemptive efforts to limit potential bank balance sheet risks.

Abstract

Sound fiscal and monetary policies have provided a strong foundation for the longest U.S. economic expansion on record. Executive Directors agreed that the U.S. economy strength had been supported by rising real income, enhanced profitability, and rising household wealth. Directors cautioned the need to reduce the domestic demand growth, and maintain monetary and fiscal policies. Directors expressed concern about the decline in personal saving, rise in household and corporate debt levels, and supported preemptive efforts to limit potential bank balance sheet risks.

I. Introduction1

1. The staff report for the previous Article IV consultation discussions was considered by the Executive Board on July 21, 2000 (EBM/00/73)2 Executive Directors agreed that the remarkable strength of the U.S. economy had been supported by rising real income, enhanced profitability, and rising household wealth, all of which were closely related to the surge in productivity growth beginning in the mid–1990s. However, Directors cautioned that continued domestic demand growth at a pace well in excess of the productivity-driven increase in potential output was not sustainable and needed to be slowed. In the near term, the principal priority for monetary policy was to ensure that the pace of aggregate demand growth was brought back in line with the economy’s potential growth to ensure that inflation was kept in check. Directors noted that fiscal policy would also have an important role to play in restraining domestic demand growth in the near term and supported the Administration’s intention to preserve a substantial share of the surpluses in prospect. From a longer-term perspective, eliminating the net public debt would be an important step toward preparing the federal government for the coming wave of unfunded liabilities associated with the aging of the population. Although Directors did not see any major vulnerabilities in the banking sector, they noted the high levels of household and corporate debt, and agreed that any substantial downturn in the economy would inevitably produce some financial pressures, and they supported pre-emptive efforts to limit potential bank balance sheet risks.

II. Economic Developments and Outlook

A. Recent Economic Developments

2. Real GDP in 2000 grew by 5 percent—the strongest rate of growth of this long expansion—but most of these gains were concentrated in the first half, with a significant slowdown emerging later in the year (Table 1, Figure 1, and Box 1). During the second half of 2000, the economy grew at an annual rate of just 1½ percent and by 1¼ percent in the first quarter of 2001. A confluence of mutually reinforcing developments in the household and business sectors weighed heavily on activity during the second half of 2000 and into 2001 and caused a sudden slowdown. Higher interest rates and energy prices cut into discretionary consumer spending and squeezed corporate profit margins; slowing sales and higher costs eroded corporate earnings; equity prices tumbled—especially in the technology sector—increasing the cost of equity capital and reducing household wealth; and risk spreads on corporate debt widened, tightening financial conditions. At the same time, consumer confidence fell reflecting concerns about future economic conditions, further compounding the adverse effects of these developments (Figure 2).

Table 1.

United States: Historical Economic Indicators

(Annual Change in percent, unless otherwise noted)

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

Contribution to GDP growth.

Private nonfarm business sector.

Business sector; in chained 1996 dollars.

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

Yearly average.

As a percent of potential GDP.

Overall balance.

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.

Figure 1.
Figure 1.

United States: Real GDP and Domestic Demand

(Percentage change, same quarter previous year)

Citation: IMF Staff Country Reports 2001, 145; 10.5089/9781451839531.002.A001

Figure 2.
Figure 2.

United States: Consumer Confidence

Citation: IMF Staff Country Reports 2001, 145; 10.5089/9781451839531.002.A001

3. Over the last several years, buoyant consumer spending underpinned the rapid pace of growth in the economy (Figure 3). Although spending in 2000 increased by 5¼ percent, similar to 1999, the largest gains were concentrated in the first quarter. The deceleration in consumer spending during the second half of 2000 and in the first quarter of 2001—to an annual rate of a little more than 3 percent—reflected declines in consumer confidence, somewhat weaker growth in household real disposable income, and lower net wealth, factors which had fueled consumer spending in previous years.3

Figure 3.
Figure 3.

United States: Real Personal Consumption Expenditures

(Percentage change, same quartet previous year)

Citation: IMF Staff Country Reports 2001, 145; 10.5089/9781451839531.002.A001

Is There a Link Between the Longevity of an Expansion and the Probability of a Downturn?

The economic expansion in the United States that began in the second quarter of 1991 has persisted for 40 quarters, the longest economic expansion on record. Some observers have suggested that the longer this expansion persists, the greater the likelihood that a downturn in activity will occur. This reflects a commonly held belief that every economic expansion sows the seeds of its own destruction, as imbalances and other excesses emerge and grow over the expansion’s lifespan. Hence, the longer the expansion goes on the higher is the probability that it will end and the more severe the downturn will be. While the latter expectation may be true, since the unwinding of imbalances and excesses built up during the expansion might contribute to a self-reinforcing downward spiral, the severity of the downturn ultimately tends to be highly dependent on the response of macroeconomic policies. However, the proposition that the longer an expansion persists, the greater is the probability of a downturn in activity is a statistically testable hypothesis and analyses of U.S. business cycles do not support this contention.

Post-war U.S. data show little evidence that the longer an economic expansion lasts, the higher the probability of a downturn in economic activity. Diebold and Rudebusch (1999) find that post-war U.S. expansions display no duration dependence.1 In contrast, evidence suggests that for recessions, the probability of an upturn rises the longer the economy contracts. More recently, Learner (2001) decomposed the U.S. business-cycle expansions since the 1950s into four distinctive phases—recovery, plateau, surge, and plateau—to estimate the probabilities of transition between phases.2 Results suggest that output growth in each phase provides little information about the probability that the phase will end, and other indicators, such as unemployment, hours worked, and profits, are needed to identify such probabilities.

1 F. Diebold F. and G. Rudebusch, 1999, Business Cycles: Duration, Dynamics and Forecasting (Princeton, N.J.: Princeton University Press).2 E. Learner, 2001, “The Life Cycle of U.S. Economic Expansions,” NBER Working Paper No. 8192.

4. In 2001, negative wealth effects associated with the stock market’s decline are expected to significantly restrain consumption growth. From its peak in March 2000, the technology-heavy NASDAQ dropped 45 percent by year-end and a further 15 percent by end-May 2001, while the broader S&P500 composite index fell 12 and 5 percent over the same periods (Figure 4). The downturn in U.S. equities was mirrored in global markets with all major stock markets incurring significant losses (Figure 5). Although total household net worth fell in 2000 for the first time in a decade, the decline was only 2 percent; the fall in the value of equity holdings was partly offset by a rise in other financial assets as households sold stocks and realized some capital gains from the earlier rise in stock prices (Figure 6). The declines in household net worth in the United Kingdom and Japan following earlier periods of asset price increases were much larger than observed so far in the United States. During these periods, a broader range of asset prices—including real estate prices—fell in these countries, whereas in the United States, the downturn (like the rise in asset prices) has been concentrated in equities.4

Figure 4.
Figure 4.

United States: Stock Market Developments

Citation: IMF Staff Country Reports 2001, 145; 10.5089/9781451839531.002.A001

Figure 5.
Figure 5.

International Comparison: Stock Market Developments

Citation: IMF Staff Country Reports 2001, 145; 10.5089/9781451839531.002.A001

Figure 6.
Figure 6.

International Comparison: Household Net Worth

(In percent of personal disposable income)

Citation: IMF Staff Country Reports 2001, 145; 10.5089/9781451839531.002.A001

Source: OECD 2000, Economic Outlook December and national data scenario.

5. Strong growth in business fixed investment contributed over 1½ percentage points to annual growth over the last few years (Figure 7). Such investment continued strong in the first half of 2000, with equipment and software purchases surging, but the pace of spending dropped markedly in the second half with this weakness persisting in the first quarter of 2001. The deceleration in investment spending reflected the slowdown in economic activity, tighter financial conditions, and concerns about future profitability. Nonresidential construction, however, remained strong throughout 2000 and into 2001.

Figure 7.
Figure 7.

United States: Real Private Fixed Investment

(Percentage change, same quarter previous year)

Citation: IMF Staff Country Reports 2001, 145; 10.5089/9781451839531.002.A001

6. Sales slackened during 2000, and inventories rose, pushing the inventory-to-sales ratio above its long-term trend in the second half of the year (Figure 8). The inventory buildup developed in a broad range of manufacturing industries, but was especially pronounced in the automotive sector. Production was cut toward the latter part of the year, which sharply slowed inventory investment; adjustments in inventories reduced real GDP growth in the fourth quarter of 2000 by ½ percentage point, and by about 3 percentage points in the first quarter of 2001.

Figure 8.
Figure 8.

United States; Total Business Inventory to Sales Ratio

Citation: IMF Staff Country Reports 2001, 145; 10.5089/9781451839531.002.A001

7. Net exports subtracted about 1 percentage point from GDP growth in 2000, reflecting the continued widening of the trade balance, but a sharp drop in imports in early 2001 dampened the impact of slowing domestic demand on real GDP growth. The current account deficit widened to 4½ percent of GDP in 2000, from 3½ percent in 1999, mainly reflecting a deterioration in the merchandise trade deficit (Table 2 and Figure 9). An increase in import volume growth from already high levels more than offset stronger exports driven by a strengthening of economic activity in partner countries (Table 3). With imports falling in the first quarter of 2001, the current account deficit declined to 4¼ percent of GDP.

Table 2.

United States: Balance of Payments

(In billions of dollars)

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Source: U.S. Department of Commerce, Bureau of Economic Analysis.
Table 3.

United States: Indicators of Economic Performance

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Sources: World Economic Outlook; and staff estimates.

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.

Figure 9.
Figure 9.

United States: Current Account

Citation: IMF Staff Country Reports 2001, 145; 10.5089/9781451839531.002.A001

8. The current account deficit in 2000 absorbed an historically high 7¾ percent of the rest of the world’s gross national saving, compared with an average of 2½ percent during most of the previous two decades. The counterpart to the widening deficit was a strong increase in net capital inflows, mainly representing net purchases of U.S. private securities in the form of bonds and equities. Flows out of U.S. Treasury securities continued, as foreigners shifted to U.S. corporate and government agency bonds. Net purchases of U.S. equities by residents of the Euro area were especially strong (Figure 10). With the continued deterioration in the current account and strong capital inflows, the net international liability position of the United States rose from 11¾ percent of GDP at end–1999 to an estimated 8½ percent of GDP at end–2000.

Figure 10.
Figure 10.

United States: Global Net Portfolio Inflows by Asset Class

Citation: IMF Staff Country Reports 2001, 145; 10.5089/9781451839531.002.A001

9. Gross national saving remained unchanged at about 18 percent of GDP in 2000, after rising from a low of around 15 percent in the early 1990s (Figure 11). The improvement in national saving over the last decade is attributable to the increase in federal government saving, which has been rising by about 1 percentage point of GDP a year since the mid–1990s, offsetting a decline in personal saving. Continuing a trend that began in the 1980s, the personal household saving rate, as measured by the national income and product accounts, fell to around zero in 2000, as it turned negative in the second half of the year. Gross domestic investment as a share of GDP has trended higher during the current expansion, reaching about 22 percent in 2000. Therefore, with government saving rising, the widening in the current account deficit reflected an increasing rate of private investment and declining personal saving.

Figure 11.
Figure 11.

United States: Trends in Saving and Investment

(In percent of GDP)

Citation: IMF Staff Country Reports 2001, 145; 10.5089/9781451839531.002.A001

10. Although headline inflation picked up beginning in mid–2000 owing to higher energy prices, core inflation (excluding food and energy) remained moderate reflecting continued gains in labor productivity and a slower rise in non-oil import prices (Table 4 and Figure 12).5 Consumer price inflation rose to 3½ percent during the course of 2000 and in early 2001. The core consumer price index increased by around 2½ percent in 2000 and slightly faster in early 2001. The core deflator for personal consumption expenditures increased by about 1¾ percent in 2000 and the first quarter of 2001.

Table 4.

United States: Inflation 1/

(Percentage change, December-over-December)

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Sources: U.S. Department of Labor, Bureau of Labor Statistics; and U.S. Department of Commerce, Bureau of Economic Analysis.

Core inflation rates exclude changes in food and energy prices.

Fourth quarter over fourth quarter.

Chained-type price index for personal consumption expenditures.

April 2001/April 2000 for PCE; May 2001/May 2000 for CPI, PPI, and Average Hourly Earnings; 2001Ql/2000Q1 for Employment Cost Index, and Unit Labor Cost.

Figure 12.
Figure 12.

United States: Indicators of Inflation

(Percentage change, same quarter previous year)

Citation: IMF Staff Country Reports 2001, 145; 10.5089/9781451839531.002.A001

11. With continued tight labor market conditions, labor costs increased during 2000 and early 2001. Employment growth decelerated sharply during the course of the year, and the unemployment rate hovered around 4 percent, but increased in early 2001 to around 4½ percent (Figure 13). After rising by just ½ percent in 1999, unit labor costs rose by 2¼ percent during 2000 owing primarily to higher wage costs, and they increased by 3½ percent in the first quarter of 2001 compared to a year earlier. Employment costs rose at an annual rate of about 4½ percent in 2000 and in the first quarter of 2001.

Figure 13.
Figure 13.

United States: Employment Growth and the Unemployment Rate

Citation: IMF Staff Country Reports 2001, 145; 10.5089/9781451839531.002.A001

12. Labor productivity growth in the nonfarm business sector increased by 4¼ percent in 2000, but it decelerated toward year-end and contracted by nearly 1½ percent in the first quarter of 2001. The acceleration in labor productivity growth beginning in the mid–1990s has played a key role in holding down price pressures during the long expansion. Recent evidence suggests that the pickup in productivity growth is closely linked to strong rates of investment in computers and software and faster growth in total factor productivity in both the computer and noncomputer sectors (Box 2).6 Despite the worldwide availability of new technologies, other industrial countries have not experienced a “U.S.-style” pickup in productivity growth, in part reflecting slower adoption and diffusion of new technology (Figure 14).7 The deceleration in productivity growth in late 2000 appears to be attributable primarily to normal cyclical influences, as firms appeared to “hoard” labor—at least initially—as output growth slowed.

Figure 14.
Figure 14.

International Comparison: IT Expenditures

(In percent of GDP)

Citation: IMF Staff Country Reports 2001, 145; 10.5089/9781451839531.002.A001

The Acceleration in Labor Productivity Growth and Prospects for Future Growth

Early studies of the acceleration in U.S. labor productivity in the second half of the 1990s found that greater efficiencies achieved in producing information technology (IT) had boosted total factor productivity (TFP)—and hence labor productivity—in these sectors, as evidenced by the plunging prices of their products.1 These price declines and technical innovations encouraged other industries to raise their investment in IT equipment and software, contributing to capital deepening and further boosting labor productivity growth. Together, the impact of producing and using IT accounted for an estimated 45 to 75 percent of the acceleration in labor productivity growth seen during the second half of the 1990s. Some observers, however, were skeptical of these results, arguing that most of the acceleration reflected the fact that the U.S. economy was growing at a rate above its long-term trend. This above-trend growth in output was said to induce a “cyclical” increase in labor productivity, implying that the increase was only temporary and possibly related to overinvestment.2

Recent studies are consistent with the view that much of the productivity pickup is structural in nature. Using industry level data, Stiroh (2001) shows that the industries outside the IT sector that invested most aggressively in IT in the early 1990s have shown the largest gains in labor productivity growth.3 Industries that intensively use IT and IT-producing industries account for virtually all of the acceleration in labor productivity growth, with industries insulated from the IT revolution contributing virtually nothing. Another study by the Council of Economic Advisers (2001) finds that about one quarter of the acceleration in productivity since 1995 is attributable to capital deepening, with the remaining three quarters attributable to a pickup in total factor productivity growth in both the computer and noncomputer sectors.4 Data on labor productivity growth by industry are also examined, and support Stiroh’s results that industries making intensive use of IT equipment have seen a greater pickup in productivity growth. Finance, retail, and wholesale trade have all seen strong growth in productivity largely attributable to improvements in the way that businesses are organized and how they are using technology. Nordhaus (2001) develops an alternative data set for measuring productivity growth based on the income side of the national accounts and finds that about half of the acceleration in labor productivity growth is attributable to the IT sector.5

Continued strong productivity growth depends critically upon further technological innovation and investment in new technology, both of which are uncertain. Examining past trends in the factors which have promoted innovation and the outlook for producing and using technology suggest cautious optimism that underlying productivity growth will remain fairly robust at least over the medium term, although the magnitude of any short-term cyclical impact is difficult to predict. Evidence suggests that innovation is expected to continue for some time, as there appears to be room for further improvements in microprocessor speed, storage, and data transmission capacity. IT prices are expected to decline further, providing strong incentives for firms to invest in IT equipment.6 At the same time, a combination of features in the United States have fostered technological innovation and its adoption. These features include strong competition, which fueled demand for cost-saving technology; increased private and public spending on research and development; strong intellectual property protection; flexibility in labor and product markets, allowing firms to reorganize work processes and business practices; and access to financing especially for new firms. Many of these factors appear to be firmly embedded in the structure of the U.S. economy.

1 For a review see P. De Masi, 2000, “Does the Pickup in Productivity Growth Mean That There Is a New Economy?” United States: Selected Issues, IMF Staff Country Report No. 00/112.2 The use of the term “cyclical” in this context has been a source of confusion because it differs sharply from the conventional idea of a cyclical change in productivity being related to variations in the intensity with which factors of production, especially labor, are used over the course of the business cycle.3 K. J. Stiroh, 2001, “Information Technology and the U.S. Productivity Revival: What Do the Industry Data Say?’ Federal Reserve Bank of New York, Working Paper, January 24.4 Council of Economic Advisers, 2001, Economic Report of the President (Washington, D.C.: U.S. GPO).5 W. D. Nordhaus, 2001, “Productivity Growth and the New Economy,” NBER Working Paper 8096, January.6 D. J. Jorgenson, 2001, “Information Technology and the U.S. Economy,” Presidential Address to the American Economic Association, January 6; and “The Productivity Experience of the United States: Past, Present and Future,” Remarks by Vice Chairman Roger W. Ferguson, Jr., at the U.S. Embassy, The Hague, Netherlands, June 14, 2001.

13. The stance of monetary policy shifted markedly in early 2001, as the Federal Reserve responded to the changing balance of risks for inflation and output growth. With domestic demand growth outstripping the growth in potential output, the Federal Reserve 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 Federal Reserve 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.

14. Interest rates on short-term Treasury securities largely mirrored the changes in monetary policy, but long-term Treasury yields declined during 2000, partly on concerns about the shrinking supply of long-term Treasury securities which imparted a scarcity premium (Figure 15). As a result, the Treasury yield curve for much of 2000 was inverted, but it became positively sloped in early 2001, and steepened significantly in the first five months of the year.

Figure 15.
Figure 15.

United States: Interest Rates

(In percent)

Citation: IMF Staff Country Reports 2001, 145; 10.5089/9781451839531.002.A001

15. Corporate bond spreads, particularly on high-yield bonds, spiked in late 2000 and bond placements dropped as evidence of a weaker economy, combined with equity price declines and a less rosy outlook for corporate profits, prompted investors to become more cautious about credit risk. Spreads in the high-yield corporate bond sector relative to AAA corporate bonds jumped to about 750 basis points in late 2000, and trading virtually seized up, raising concerns that a credit crunch would ensue (Figure 16). Some spillover to investment grade bonds also occurred, where yield spreads widened but to a much lesser extent. With the Federal Reserve’s easing in monetary policy in the first six months of 2001, credit spreads narrowed, but remain high relative to their levels in early 2000.

Figure 16.
Figure 16.

United States: Corporate Yield Spreads

(Basis points on 10 year AAA corporate)

Citation: IMF Staff Country Reports 2001, 145; 10.5089/9781451839531.002.A001

16. In real effective terms, the dollar appreciated by 7¾ percent in 2000, and by a further 6 percent in the first five months of 2001. By May 2001, it was about 55 percent higher than its low in April 1995 (Figure 17). A 5 percent depreciation of the dollar against the Japanese yen in 2000 was more than offset by a 15¾ percent appreciation againt the euro; during the first five months of 2001, the dollar appreciated against both the Japanese yen and the euro.

Figure 17.
Figure 17.

United States: Bilateral and Real Effective Exchange Rates

(Index 1990=100)

Citation: IMF Staff Country Reports 2001, 145; 10.5089/9781451839531.002.A001

17. The unified federal budget balance recorded a surplus for the third successive year in FY2000 (Figure 18). The surplus rose to 2½ percent of GDP ($236 billion), from 1¼ percent of GDP in FY 1999.8 The Administration and the Congressional Budget Office both estimate that in FY 2001, on a current services basis, the surplus will rise to 2¾ percent of GDP (around $280 billion).9 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 (OBRA93) and the Balanced Budget Act of 1997. In FY 2000, federal debt held by the public declined to 35 percent of GDP. The state and local government budget deficit (national accounts basis) is estimated to have remained roughly unchanged in 2000 at about ½ percent of GDP and is expected to stay at that level in 2001. The turnaround in the U.S. general government financial balance over the period 1995–2000 was larger than the average for the other G7 countries (see Table 3).

Figure 18.
Figure 18.

United States: Administration’s Budget Projections

(In percent of GDP; fiscal years)

Citation: IMF Staff Country Reports 2001, 145; 10.5089/9781451839531.002.A001

B. Economic Outlook

18. The staffs baseline projection is that real GDP growth will slow through the first half of 2001, primarily reflecting weakness in business spending owing to a decline in corporate profitability. A lower rate of equipment and software investment, moderate consumption growth, some increase in unemployment, and relatively sluggish growth in the rest of the world will contribute to a slow revival in output growth over the course of 2001 but no outright recession. The modest pickup in growth in the second half of the year would be supported by the aggressive easing of monetary policy, fiscal stimulus from the recently enacted tax cuts (Box 3), and completion of the inventory adjustment process. GDP growth for the year 2001 as a whole is expected to be about 1½ percent (Table 5).10

Table 5.

United States: Economic Outlook

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

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Source: Staff estimates.

Contribution to GDP growth.

Fiscal year. Based on the Administration’s FY 2002 budget proposal, adjusted for staffs macroeconomic assumptions.

The Short-Term Economic Impact of the Tax Cuts

The recently enacted tax cut legislation provides for short-term stimulus in the form of lump sum tax rebates and reductions in tax withholding schedules effective July 1, 2001. The staff estimates that the direct effect will be to raise personal disposable income by $48 billion (½ percent of GDP) in 2001 and $76 billion (¾ percent of GDP) in 2002.

The short-term impact on aggregate demand will depend on several factors, including;

  • whether the tax rebate is viewed as a down payment on future tax cuts and the extent to which it is spent rather than saved;

  • the distribution of the tax rebate and withholding tax changes across income groups, with higher-income groups having greater propensities to save;

  • the extent to which individuals view the current reduction in taxes as potentially leading to future tax increases (so-called Ricardian effects).

Depending on the assumptions for these factors, the short-term stimulus from the tax cut could be expected to add 1–2 percentage points (annual rate) to GDP growth in the second half of 2001 or ¼–½ percentage point to average growth for the year as a whole, and ½–¾ percentage point to growth in 2002.

Economic activity would strengthen further throughout 2002, with real GDP rising by 2½ percent for the year, and it would be faster than the staffs estimate of potential output growth of 3¼ percent in 2003–04, as the economy revives. Although in recent months there has been a pickup in wage costs, with the slow recovery in economic activity in the near term, inflationary pressures are expected to remain quiescent. The current account deficit as a percent of GDP is expected to narrow gradually over the medium term, as incomes are projected to grow somewhat faster in the rest of the world relative to the United States.11

19. However, the outlook for the U.S. economy is very uncertain. Although consumer confidence fell sharply, household spending held up reasonably well in the first quarter of 2001, with particularly strong purchases of cars and houses. It is possible that economic activity may revive more quickly in the latter part of 2001 and in 2002 than in the baseline forecast. In this case, the slowdown would largely reflect an inventory correction that runs its course during 2001, and rising business and consumer confidence would contribute to a faster pickup in growth. Accordingly, growth could be ½ percentage point higher in 2001 and 1 percentage point higher in 2002 than the baseline forecast. In such an event, the Federal Reserve would have to begin unwinding the easing in monetary policy much earlier in order to prevent the emergence of inflationary pressures.

20. But there is a significant risk that an additional slide in business confidence, owing in part to a more pessimistic assessment of underlying productivity growth and corporate earnings prospects, could create the conditions for a further deterioration in U.S. economic activity, with adverse consequences for the global economy. As a result, unemployment would rise, dampening household income and consumer spending. Productivity growth would be expected to experience a cyclical decline, and the extent to which this development would further reduce profitability and add to unemployment would depend on the flexibility of wages. Moreover, the initial downturn could be amplified by triggering adjustments in corporate and household balance sheets, which in turn would have negative effects on the financial sector, leading to a tightening of credit. Lower expected corporate earnings would also add to downward pressures on stock prices and would contribute to increase risk aversion and a further tightening of credit conditions, which would restrain consumption and investment.

21. The potential implications of some of the downside risks for the United States and the rest of the world arising from a negative shock to business confidence have been explored using MULTIMOD to simulate an alternative scenario (Table 6). The effect on business confidence of less optimistic expectations for future earnings and underlying productivity growth are assumed to contribute to an additional decline in U.S. equity prices of 20 percent in the scenario, leading global investors to move out of dollar-denominated assets and inducing a depreciation of the dollar. Because of the decline in the U.S. stock market, equity prices in Europe and Japan are assumed to fall further, and Japan also sustains a sharp drop in consumer and business confidence. The results from this scenario indicate that the United States would experience a significant slowdown in real GDP growth in 2001–03 relative to the baseline, with real output recovering only slowly over the medium term. Among the industrial countries, Europe and Japan would experience less of a slowdown in growth than the United States.12 For developing countries, there would be a modest decline in real GDP, but a more significant decline in real domestic demand. For countries with substantial trade and financial linkages with the United States, such as Canada and Mexico, the slowdown in growth is likely to be closer to that in the United States.13 The fall in output in the industrial countries would reduce exports from developing countries, lower commodity prices, and reduce capital flows. Global monetary conditions would be eased in. response to weakening activity, and this would provide some boost to the developing countries, particularly the regions which are heavily dependent on foreign borrowing, such as Latin America. However, turbulence in U.S. financial markets and an increase in risk aversion could spill over onto the emerging market countries and, through higher spreads on emerging market debt, would tighten external financing conditions and further constrain growth prospects (Box 4).

Table 6.

United States: Alternative Scenario to Illustrate Potential Downside Risks

(Percent deviation from baseline levels, unless otherwise noted)

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Source: Based on IMF, World Economic Outlook, May 2001.