United States
2004 Article IV Consultation—Staff Report; Staff Supplement; and Public Information Notice on the Executive Board Discussion
Author: International Monetary Fund
Publication Date:
30 Jul 2004
eISBN:
9781451839616
Language:
English
Keywords:
ISCR; CR; FOMC decision; core consumer price index; price; monetary policy report; inflation objective; trade balance; real GDP; exchange rate; current account
Download PDF (612.5 KB)

This 2004 Article IV Consultation highlights that following a rather tepid recovery, the United States economy gathered strength in 2003. Supported by continued robust productivity growth, real GDP growth began to exceed the growth rate of potential output around midyear. The recovery broadened in early 2004 as payroll employment strengthened, easing concerns that a lack of employment growth and correspondingly weaker household income could weigh on consumer demand. Strong productivity growth has also contributed to significant improvements in corporate and financial balance sheets.

Abstract

This 2004 Article IV Consultation highlights that following a rather tepid recovery, the United States economy gathered strength in 2003. Supported by continued robust productivity growth, real GDP growth began to exceed the growth rate of potential output around midyear. The recovery broadened in early 2004 as payroll employment strengthened, easing concerns that a lack of employment growth and correspondingly weaker household income could weigh on consumer demand. Strong productivity growth has also contributed to significant improvements in corporate and financial balance sheets.

I. Introduction and Executive Summary

State of the economy

1. The 2004 consultation discussions took place against increasing signs that the recovery was becoming self-sustaining. Although the 2001 recession was relatively shallow, it was followed initially by an unusually tepid recovery, as a series of negative shocks offset unprecedented fiscal and monetary stimulus. Nonetheless, labor productivity growth remained remarkably robust and an increase in the momentum of the recovery over the last year has been followed more recently by a long-awaited improvement in employment growth. A pickup in price pressures also appears to have fully erased earlier deflation fears.

Policy stance

2. As a result, the focus of both monetary and fiscal policies has shifted toward consolidation. After commendably aggressive and effective action to address the deflation risks that emerged last year, the monetary authorities have now clearly signaled that stimulus will be withdrawn soon, albeit at a measured pace. While emphasizing a commitment to make recent tax cuts permanent, the FY 2005 budget also aimed to halve the budget deficit over the next five years, largely through significant spending restraint.

Discussions

3. Against this background, the policy discussions focused on how to manage the withdrawal of stimulus and ensure long-run fiscal sustainability, in particular:

  • Restoring a sustainable fiscal position. With entitlement programs significantly underfunded and an external current account deficit of 5 percentage points of GDP, early steps are needed to establish a credible plan to restore fiscal surpluses and reform health and retirement programs.

  • Ensuring an orderly withdrawal of monetary stimulus. Having successfully forestalled earlier deflation risks, the challenge is now to return interest rates to neutral levels without disrupting financial markets or kindling inflation.

  • The global ramifications of the U.S. economy and policies. The U.S. recovery has led the global upturn; looking ahead, key issues include the impact of monetary policy tightening on exchange rates and global borrowing conditions, including in emerging markets, and the spillover effects of U.S. fiscal policy on global investment.

II. Recent Economic Developments

4. With the broadening of the economic recovery in recent months, concerns have shifted from the sustainability of the upturn to the possible emergence of inflationary pressures (see the figure on the next page, (Table 1–2). Following an initially anemic recovery from the 2001 recession, economic activity began to gather steam in 2003, with real GDP growth beginning to exceed potential around mid-year. The acceleration in growth since last year’s consultation has been somewhat stronger than anticipated and has provided welcome support to the global recovery. Risks that a lack of employment growth and correspondingly weaker household incomes could derail the recovery have dissipated earlier this year as payroll employment finally started to accelerate.

Table 1.

United States: Selected Economic Indicators

(Change from previous period in percent, unless otherwise indicated)

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Sources: Haver Analytics; and preliminary IMF staff calculations.

Contributions to growth.

Staff projections allow for differences in macroceconomic assumptions, as well as incorporating AMT reform and somewhat faster spending growth.

NIPA basis, goods and services.

Table 2.

United States: Monthly Indicators

(Percent changes from previous period, unless otherwise indicated)

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Source: Haver Analytics.
uA01fig01

An uprecedented degree of policy stimulus has supported output recently…

Citation: IMF Staff Country Reports 2004, 230; 10.5089/9781451839616.002.A001

uA01fig02

…reflecting both monetary and fiscal stimulus.

Citation: IMF Staff Country Reports 2004, 230; 10.5089/9781451839616.002.A001

Sources: Haver Analytics; IMF staff calculations; and Macroeconomic Advisors, a private sector consultancy.1Financial and fiscal stimulus are calculated by Macroeconomic Advisors, based on their macroeconomic model.2Financial conditions include the impact of the interest rate, the exchange rate, and stock market valuations on the economy.

5. Monetary and fiscal policies have provided significant support to activity. The Federal Reserve has eased aggressively since 2001 and—with deflation becoming a growing concern—cut the federal funds rate to a 40-year low of 1 percent in mid-2003. Post-war lows in long-term interest rates helped spur a boom in housing markets and offset the effect on household demand from the equity price collapse in 2001. Domestic demand has also been supported by fiscal stimulus, with the structural fiscal balance shifting by some 5 percentage points of GDP since 2001 due to tax cuts, temporary investment incentives, and a rapid increase in government outlays. Lower interest rates helped trigger a depreciation of the dollar and stem the drag on activity from weak growth abroad as well as from the effects of the dollar’s strong appreciation during 1995–2001.

uA01fig03

The recovery has been marked by strong growth in productivity and profits, but recovery of investment and employment has lagged, although recently they have both started to turn up.

Citation: IMF Staff Country Reports 2004, 230; 10.5089/9781451839616.002.A001

Source: Haver Analytics and IMF staff calculations.

6. However, macroeconomic stimulus is starting to wane. Financial conditions have tightened somewhat in recent months as stronger data and statements from Fed officials have led to expectations that monetary stimulus will soon begin to be removed. The 10-year benchmark bond yield, in particular, has risen by around a percentage point since late March, and part of the dollar’s earlier depreciation has been reversed. On the fiscal front, the stimulus from this year’s surge in personal tax refunds associated with the 2003 tax cuts is starting to fade, and investment incentives generated by accelerated depreciation allowances are slated to expire at end-December.

7. Increasing asset prices have helped support aggregate demand. Equity markets have risen nearly 50 percent from their lows just before the Iraq war, although prices have stagnated somewhat in recent months on concerns that the removal of monetary stimulus would hurt corporate earnings. House prices have continued to increase rapidly, further boosting household balance sheets, and a temporary surge in refinancing activity in the first months of 2004 reflected households’ efforts to reduce interest payments and lengthen debt maturities ahead of an expected tightening of interest rates.

8. Labor productivity growth remains remarkably strong, and has accelerated compared with the late 1990s (Box 1). Productivity growth rose strongly in the latter half of the 1990s and has accelerated further through the current cycle, moving U.S. growth ahead of major competitors (Table 3). Although this recent strength appears to reflect partly temporary factors, there is increasing evidence that it also reflects the reorganization of production in response to the IT revolution and other innovations in business practices, suggesting a further upward shift may have also taken place.1

uA01fig04

Labor productivity growth has been robust recently, even compared to the late 1990s.

Citation: IMF Staff Country Reports 2004, 230; 10.5089/9781451839616.002.A001

Source: Haver Analytics.
Table 3.

Major Industrial Countries: Indicators of Economic Performance

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Sources: World Economic Outlook; and IMF staff calculations.

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.

On national accounts basis.

9. Job creation was unusually slow compared with other cyclical episodes, but has begun to revive in the last few months. Tepid employment earlier in the recovery appears to have largely reflected cost cutting in the face of uncertain growth and geopolitical prospects but, as confidence has firmed over the last few months, almost a million new jobs have been created and the unemployment rate has fallen to 5.6 percent. Although data are sketchy, offshoring of jobs appears too small to have any significant impact on these overall trends.2 By contrast, the expansion of the U.S. labor force due to immigration appears to have contributed to the longer-term growth of the U.S. economy, while also enabling the flow of remittances to lower-income countries, most notably in Central America and Mexico.3

Inflation and Productivity

After an extended period of disinflation, price increases are starting to accelerate. Inflation rates have reversed much of last year’s decline, with the core personal consumption expenditure (PCE) deflator moving up to 1.6 percent (yoy) in May 2004, from 0.8 percent (yoy) at end-2003 (Chart).

uA01fig05

Price Indices

Citation: IMF Staff Country Reports 2004, 230; 10.5089/9781451839616.002.A001

The pickup of inflation reflects in part the effects of the global recovery and geopolitical events on commodity and other upstream prices. Increasing global output has led to a general increase in raw material prices and, together with tensions in the Middle East and elsewhere, has led to a spike in energy prices, which futures markets indicate could be more long-lasting than those caused by the Gulf or Iraq wars. Producer prices of crude and intermediate materials excluding food and energy have risen 22 percent and 5 percent, respectively, over the 12 months ended May 2004, while the weaker dollar contributed to a 3 percent rise in non-oil import prices. Although the pass-through to final prices has historically been small—past estimates suggest a permanent 10 percent rise in raw materials costs is associated with a 0.1 percent or less increase in final consumer prices—the magnitude of the upstream price increases has caused concern.

Inflationary pressures may be dampened by significant economic slack in factories and labor markets. While real GDP has expanded at a brisk 5 percent over the past year, at 76 percent, the manufacturing capacity utilization rate remains well below the long-term average of 82 percent. The unemployment rate remains above most estimates of the NAIRU, which center at around 5 percent, and the low labor force participation rate may represent additional slack through “hidden unemployment.” Staff estimates show that monthly job gains of 300,000 would be needed to bring the economy to full employment in late 2005 or early 2006, after allowing for a rise in the participation rate and growth of the labor force.

A key determinant of current and future price pressures is the rate of growth of labor productivity. For a given rate of growth of activity, higher underlying labor productivity growth implies more economic slack and a slower return to potential. Output per hour has risen at a 3¾ percent annual pace since 2000, leading to speculation that in addition to cyclical factors, the underlying trend has accelerated further from the already elevated 2½ percent rate recorded in the late 1990s. As a result of this rapid increase in productivity, unit labor costs have declined (yoy) for a record nine consecutive quarters, helping hold price pressures in check (Chart).

uA01fig06

Productivity and Labor Costs

Citation: IMF Staff Country Reports 2004, 230; 10.5089/9781451839616.002.A001

Data suggest that the improved performance of the U.S. economy since 1995 reflects a broad-based acceleration in total factor productivity (TFP) rather than just the gains in the information technology sector. Recent research has found an acceleration in TFP growth across a range of industries outside of the IT sector as businesses use new technologies and other innovations to improve the efficiency of production (see Chapter 1 of the accompanying Selected Issues paper).

Faster labor productivity growth may also temporarily reduce employment. Analysis by the staff and others finds that increases in output per worker reduces employment, but that this effect lasts only about a year-and-a-half. This suggests that the recent acceleration in labor product growth may help explain both the limited job creation over much of the recent recovery and hence some of the muted inflationary pressures that have been observed, but is unlikely to have significant consequences for job growth over a longer period.

Note: The author of this box is Calvin Schnure.

10. The business and financial sectors have strengthened as a result of productivity growth and the recovery. With a sharp rebound in profits and investment spending at a low ebb, the nonfinancial corporate sector is in the unusual position of being a net provider of funds to the rest of the economy. The share of after-tax profits in GDP has risen to a post-war high as firms have strengthened their balance sheets and taken advantage of low bond rates and narrowing corporate spreads to extend the maturity of their debt even as investment spending has started to pick up. At the same time, the banking system booked record profits in 2004Q1 and near-record returns on assets.

uA01fig07

Nonfinancial corporations are currently providing funds to the rest of the economy.

Citation: IMF Staff Country Reports 2004, 230; 10.5089/9781451839616.002.A001

Source: Haver Analytics.

11. Oil prices have spiked upward as faster global growth has spurred demand. Industry analysis suggests that rapid demand growth in China and elsewhere has reduced the supply cushion to unusually low levels, while geopolitical developments have also raised fears of possible supply disruptions. The spike in energy prices—which also reflects supply constraints in the natural gas sector—has raised overall inflation, but pass-through to non-energy prices has been limited. Nonetheless, higher fuel bills are expected to erode discretionary income and dampen aggregate demand, while boosting the current account deficit.4

uA01fig08

Core inflation has started to increase on upstream presssures, but unit labor costs remain contained.

Citation: IMF Staff Country Reports 2004, 230; 10.5089/9781451839616.002.A001

Source: Haver Analytics.

12. Fears of deflation have recently been replaced by concerns that price pressures are growing. After falling to a 40-year low of around 1 percent in early-2004, year-on-year core inflation has recently started to rise, reaching over 1½ percent in May.5 The recent increase reflects a deceleration of deflation in goods prices as the global recovery has increased costs of materials and intermediate inputs, most notably energy. The depreciation of the dollar has added to these pressures, although the exchange rate pass-through of the weaker dollar appears to have been limited as foreign firms have reduced profit margins or benefited from earlier hedging.6 At the same time, rapid labor productivity growth continues to dampen unit labor costs, and service price inflation remains moderate.

uA01fig09

The current account projected to deficit 4-5 percent of GDP even after the dollar’s depreciation and anticipated faster partner-country growth.

Citation: IMF Staff Country Reports 2004, 230; 10.5089/9781451839616.002.A001

13. The current account deficit is close to its record high of 5 percent of GDP—representing around 6 percent of global saving—despite some dollar depreciation (Table 4–5). While the dollar has rebounded somewhat in recent months on expectations of monetary tightening, in real effective terms, it remains some 10 percent below its peak in early 2002, partly reversing its appreciation since the mid-1990s. The depreciation has been almost exclusively against industrial country currencies, while the competitive position against major developing country partners has remained largely unchanged. The effect of the weaker dollar on real net exports, which continued to subtract from real GDP growth in 2003 and early 2004, has been modest, reflecting the usual lags between changes in real exchange rates and trade volumes as well as the relatively slower revival of foreign demand.

Table 4.

United States: Balance of Payments

(In billions of dollars, unless otherwise indicated)

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Source: Haver Analytics.