United States
2006 Article IV Consultation: Staff Report; Staff Statement; and Public Information Notice on the Executive Board Discussion

The U.S. economy continued to grow strongly over the year even in the face of a withdrawal of monetary stimulus and high oil prices. Executive Directors commended the Federal Reserve for its monetary tightening. They recognized that the financial sector has proven innovative and resilient. They cautioned that demographic and other pressures will continue to threaten long-term fiscal sustainability and economic prospects. They agreed that the country has a key role in catalyzing vigorous implementation of the cooperative strategy laid out by the International Monetary and Financial Committee.


The U.S. economy continued to grow strongly over the year even in the face of a withdrawal of monetary stimulus and high oil prices. Executive Directors commended the Federal Reserve for its monetary tightening. They recognized that the financial sector has proven innovative and resilient. They cautioned that demographic and other pressures will continue to threaten long-term fiscal sustainability and economic prospects. They agreed that the country has a key role in catalyzing vigorous implementation of the cooperative strategy laid out by the International Monetary and Financial Committee.

I. Outlook and Key Issues

1. The U.S. economy has continued to be an engine of global growth despite monetary tightening and high oil prices (Figure 1). Over the last year, household spending remained robust, spurred by mortgage borrowing and double-digit house price inflation. However, with employment and wage growth remaining modest, the household saving ratio dropped into negative territory. As a result, and notwithstanding strong business saving and an improvement in the fiscal balance, the current account deficit reached a new record high.

Figure 1.
Figure 1.

Economic Activity: Recent Developments and Outlook

Citation: IMF Staff Country Reports 2006, 279; 10.5089/9781451839661.002.A001

Sources: Haver Analytics; International Monetary Fund, World Economic Outlook; and Fund staff estimates.

2. Officials and staff both expect a “soft landing,” with growth easing to potential and inflation remaining contained (Tables 1 and 2).1 The housing market is likely to cool in response to high valuations and tightening financial conditions, causing the impetus from consumption and residential investment to wane, but strong fundamentals should continue to support business investment. The external deficit is likely to remain wide, but the drag on activity from net exports will lessen as growth abroad strengthens. On the supply side, solid productivity growth should accommodate wage gains while containing price pressures.

United States: Medium-Term Projections

(Percent change from previous period, unless otherwise indicated)

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Sources: Haver Analytics; and Fund staff estimates.

Contributions to growth; NIPA basis, goods and services.

In percent of GDP.

Average petroleum spot price: simple average of U.K. Brent, Dubai, and West Texas prices.

Table 1.

Selected Economic Indicators

(Percentage change from previous period at annual rate, unless otherwise indicated)

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Sources: Haver Analytics; and Fund staff estimates.

Contributions to growth.

NIPA basis, goods.

Table 2.

Economic Performance of Major Industrial Countries

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Sources: IMF, World Economic Outlook; and Fund staff estimates.

National accounts basis.

3. Staff and officials also concurred on the sources of macroeconomic uncertainties, but had somewhat different perceptions of the balance of risks (Figure 1 shows fan charts, whose construction is discussed in Annex I):

Fund-U.S. Relations

The United States and the Fund enjoy a close relationship, reflecting a consensus on the fundamental factors underpinning growth in market-based economies. Chief among those are a commitment to free trade, the strong role of property rights and sound institutions, flexible labor and product markets, a deep financial system, a relatively small size of government, and a high degree of transparency of economic policy decisions.

Within this broader consensus, both sides have taken different views on the amount of U.S. fiscal adjustment needed to prepare for population aging and the role of tax policy. While both sides agree that entitlement reform is key to long-term sustainability, the Fund has been advocating a more determined effort at fiscal consolidation to prepare for population aging. The Administration aims to reduce the deficit to around its long-term average of 1½-2 percent of GDP, and has ruled out revenue measures to achieve more ambitious deficit reduction.

The authorities also remain skeptical about the role of U.S. fiscal policy in reducing global current account imbalances. The authorities commended bilateral surveillance of the United States for integrating analysis from the Fund’s World Economic Outlook and other sources.1 However, they have discounted staff arguments that fiscal adjustment in the United States by itself could contribute significantly to an orderly adjustment of global current account imbalances, presenting their own analysis to suggest that the U.S. current account deficit is relatively insensitive to U.S. fiscal policy.2

Nevertheless, the United States has been a key voice for strengthening the role of the Fund in resolving global imbalances. Treasury officials have called on the Fund to strengthen its surveillance over members’ exchange rate policies and have supported the introduction of multilateral consultations, reflecting the authorities’ view that the resolution of global current account imbalances is a shared responsibility.

U.S. legislation has also been seeking to promote sound economic policies internationally through the work of the Fund. The U.S. Executive Director is obliged to pursue slightly more than 70 legislative mandates (as of August 2005) prescribing U.S. policy goals at the Fund, ranging from exchange rate stability to strengthened financial systems, good governance, AML/CFT, and U.S. voting positions on assistance to individual borrower countries. Progress toward these goals is evaluated in annual reports by the U.S. Treasury and the U.S. Government Accountability Office (GAO) to Congress.3

The authorities’ agreement to discuss the modalities of a Financial Sector Assessment Program (FSAP) provides a welcome recognition of the Fund’s work on financial sector soundness. The United States is the last G-7 country yet to agree to an FSAP, which has been a long-standing recommendation by staff.

1 “Working with the IMF to Strengthen Exchange Rate Surveillance,” Remarks by Under Secretary for International Affairs Tim Adams at the American Enterprise Institute, February 2, 2006.2 See M. Barth and P. Pollard, “The Limits of Fiscal Policy in Current Account Adjustment,” Department of the Treasury, Office of International Affairs, Occasional Paper No. 2, 2006.3 See “Implementation of Legislative Provisions Relating to the International Monetary Fund: A Report to Congress,” Department of the Treasury, November 2005.
  • Staff considered risks to growth to be on the downside. The possibility of a more abrupt slowdown in the housing market, possible disappointments on the productivity front, and a disorderly adjustment to global imbalances more than offset the upside potential for business investment. Further, more difficult to quantify downside risks stemmed from avian flu and geopolitical events. Officials regarded risks as relatively balanced as they were more sanguine about the potential impact of the housing slowdown on spending and placed greater weight on upside potential from business investment, exports, and productivity.

  • Staff suggested that the risks to inflation were on the upside. These stemmed largely from supply effects, including the possibility of a larger-than-anticipated productivity slowdown pushing up unit labor costs and the potential for pass-through of high commodity prices. Federal Reserve officials acknowledged the risks from commodity prices but were less concerned about downside risks to productivity growth.

4. Against this outlook, growing global current account imbalances, and the imminent retirement of the “baby boom” generation, the discussions focused on:

  • Maintaining noninflationary growth. With policy interest rates having risen to around neutral, and output and inflation risks somewhat skewed, monetary policy decisions had become more delicately balanced.

  • Preserving domestic and external financial stability. For example, U.S. policies could reduce risks from financial market volatility stemming from a disorderly resolution of global external imbalances.

  • Preparing for an aging population. This involves reforming unsustainable entitlement programs and potentially pursuing more forceful medium-term public debt reduction to cope with spending pressures as the baby boom generation retires.

II. Monetary Policy: Maintaining Noninflationary Growth

A. How Fast Will Household Spending Slow?

5. Household spending has been the main driver of the expansion, boosted by the housing boom (Figure 2). With capital gains—particularly on houses—boosting personal wealth, real consumption and residential investment spending has grown an average ½ percentage point faster than GDP since the 2001 recession. Real disposable income growth has been held back by rising energy prices and lackluster employment growth, and household saving turned negative as spending was financed in part through home equity withdrawal (HEW), which rose to a record 8 percent of U.S. personal income in 2005.

Figure 2.
Figure 2.

Household Activity and Balance Sheets

Citation: IMF Staff Country Reports 2006, 279; 10.5089/9781451839661.002.A001

Sources: Federal Reserve Board, Survey of Consumer Finances; Haver Analytics; Australian Bureau of Statistics; Bank of England; and Fund staff calculations.

6. Staff and officials agreed that easy financing conditions and flexible U.S. financial markets had supported the housing market and contributed to a record housing equity withdrawal (HEW) ratio (Figure 3). Mortgage securitization had helped channel foreign savings into the U.S. housing market while allowing mortgage originators greater flexibility to diversify credit exposures and reduce systemic risk. Innovative mortgage instruments, low refinancing costs, and access to tax-advantaged home equity loans, had also supported HEW.

Figure 3.
Figure 3.

Housing Market Indicators

Citation: IMF Staff Country Reports 2006, 279; 10.5089/9781451839661.002.A001

Sources: Haver Analytics; National Sources; and Fund staff calculations.1/ See Chapter 2 of United States: Selected Issues (IMF Country Report 03/245) for a description of the methodology.

7. Staff observed that, while conditions varied across regions, U.S. house prices seemed overvalued and a correction appeared to have started (Chapter 1 of the Selected Issues paper suggests house prices are 15–20 percent above equilibrium). Fed officials did not disagree with this assessment but cautioned that such estimates were subject to considerable uncertainty and varied considerably across models. Moreover, empirical evidence suggested that the impact of personal income and employment conditions on house prices tended to dominate that of long-term interest rates, suggesting that less favorable financing conditions were unlikely to represent a significant shock to prices.2

8. Staff and officials agreed that a cooling in the housing market was likely to dampen consumption and residential investment. The mission suggested that, with real house price inflation likely to halve to 5 percent in 2006 (yoy) and decelerate further subsequently, the increasing use of HEW and nontraditional mortgages implied that the sensitivity of consumption to a change in housing wealth would probably be at the upper end of the usual estimate of 3–7 cents per dollar. Once the impact on residential investment was added, this implied a reduction in GDP growth of around ½ percent of GDP over the next two years (Annex I). Background work, summarized in Annex II. 1, illustrates that in the U.K. and Australia, countries that experienced HEW ratios similar to that in the United States in recent years, slowing house price inflation led to a manageable rebound in household saving.

9. Staff viewed the balance of risks for household spending and residential investment as being on the downside. A faster deceleration in house prices could further amplify the impact on consumer and residential spending by eroding confidence and increased the strain on borrowers. These risks were exacerbated by the negative household saving rate and continued high energy prices that reduced discretionary spending power. Fed officials responded that, given the surprising strength of consumption over many years, smaller effects from slowing house prices and high energy costs were also possible.

B. Will Business Investment Surprise on the Upside?

10. Fed officials viewed the recent strength of business investment as consistent with underlying fundamentals. While business investment had been weak in the aftermath of the IT bubble, officials viewed the trends in the capital/labor ratio and other indicators as suggesting that any post-IT bubble overhang had been worked off. Continuing declines in capital goods prices and strong demand had made capital accumulation attractive even as interest rates had become less stimulative. As a result, purchases of (especially IT) equipment and software had accelerated to levels not seen since the late-1990s. Real growth in structures had been less strong and, given high office vacancy rates, officials expected this trend to continue.

11. Officials and staff agreed that business investment could surprise on the upside. In line with global trends, the corporate sector had used high profits and low interest rates to strengthen balance sheets—including through equity buybacks—and accumulate large cash holdings, taking on the unusual position of a net lender (Figure 4).3 Although an expected weakening in consumption growth could have some dampening effect on business spending, extremely strong fundamentals—the near-record profit rate, healthy expected earnings growth, low leverage, and the still low cost of capital—suggested upside risks dominated.

Figure 4.
Figure 4.

Corporate Sector Indicators

Citation: IMF Staff Country Reports 2006, 279; 10.5089/9781451839661.002.A001

Sources: Haver Analytics; Thomson One Analytics; Consensus Forecasts; and Fund staff calculations.

C. Are Price Pressures Building?

12. Fed officials acknowledged that the recent uptick in core inflation had been discouraging. The unemployment rate—at 4¾ percent in April—had fallen to the low end of most estimates of the NAIRU, and capacity utilization was around its long-run average. Nevertheless, unit labor cost increases had been contained, reflecting solid productivity growth and modest wage gains. Officials noted that the absence of wage pressures could indicate a lower level of the NAIRU, although other structural factors, including globalization, could also have played a role. Staff analysis (summarized in Annex II. 2) suggests that low inflation in recent years has largely reflected a larger-term downward trend. This has been somewhat reinforced by cyclical factors, including through globalization, that could reverse as the domestic and global environment evolves.4

13. Officials expected wage pressures to pick up over the coming year, but did not anticipate much pass-through to overall inflation. The post-2000 drop in labor market participation (discussed in Chapter 2 of the Selected Issues paper) was unlikely to be reversed. Thus, low unemployment could eventually lead to a pick-up in wage growth and some recovery of the labor share of national income (Figure 5).5 However, this would not necessarily translate into inflation, given strong productivity growth and room for downward adjustments to profit margins.

Figure 5.
Figure 5.

Labor Market Indicators

Citation: IMF Staff Country Reports 2006, 279; 10.5089/9781451839661.002.A001

Sources: Haver Analytics; World Economic Outlook; and Fund staff calculations.

14. Officials also observed that the boom in commodity prices implied a short-term inflation risk. Energy prices now seemed to be feeding into inflation expectations, and this process might not yet be complete even if energy prices remained at their present level. While the impact of higher oil prices on the economy had been smaller than in the past, partly reflecting the reductions in oil intensity of production and productivity growth (staff analysis is contained in Chapter 3 of the Selected Issues paper), there continued to be a risk of price shocks related to bottlenecks in some key segments of the U.S. energy infrastructure.6

D. Monetary Policy Discussions

15. The technical discussions took place before the increase in financial market volatility of May-June and the associated heightened concerns voiced about inflation, including by senior Fed officials. The global sell-off of riskier assets—most notably global equities and emerging market bonds—confirmed incipient evidence that the credit cycle was turning but has not had a significant impact on private sector assessments of U.S. growth prospects or financial vulnerabilities.

16. At the time of the meetings, staff suggested that, at 5 percent, the federal funds rate was close to most estimates of a neutral level (Figure 6). With inflation risks on the upside, however, a “risk management” approach to monetary policy—which took into account both the likely path of the economy and the risks around that path—could suggest the need for some further tightening, consistent with market expectations of a further rise in the federal funds rate by 25 basis points in subsequent months.

Figure 6.
Figure 6.

Monetary Policy Indicators

Citation: IMF Staff Country Reports 2006, 279; 10.5089/9781451839661.002.A001

Sources: Bloomberg L.P.; Haver Analytics; and Fund staff calculations.

17. Officials responded that the direction of future policy decisions had become much less certain than earlier, when the federal funds rate was well below the neutral range. The May 10 Federal Market Open Committee (FOMC) statement reflected these considerations, noting that while “a further policy firming may yet be needed to address inflation risks … the extent and timing of any such firming will depend importantly on the evolution of the economic outlook as implied by incoming information.” Reflecting heightened inflation concerns, the FOMC raised the Fed funds rate to 5¼ percent on June 29 and the accompanying statement observed that while “some inflation risks remain … any additional firming will depend on the evolution of the outlook for both inflation and economic growth.”

18. Fed officials noted that policy decisions were complicated by uncertainty about the factors contributing to low long-term bond yields. If low term premiums reflected a shift in portfolio preferences toward long-term assets—possibly in response to the “great moderation” in macroeconomic volatility in recent decades—short-term interest rates would need to be higher than otherwise to offset the boost to demand from lower long rates. Conversely, if low term premiums reflected a weakening of global investment demand or higher global saving that helped contain domestic price pressures, a tightening would not be warranted.

19. They observed that the impact of global financial market integration on the monetary transmission mechanism was equally difficult to assess. Staff suggested that increased integration of national bond markets could help explain the muted rise in long-term interest rates and the correspondingly subdued response of demand components to U.S. monetary tightening. Officials responded that it was difficult to gauge how the monetary transmission mechanism had changed in recent years, but they noted that recent movements in long-term interest rates seemed to reflect a relatively accurate anticipation of the pace and timing of Fed tightening, and the response of demand to these interest rate movements was consistent with past trends.

20. Fed officials did not see rising commodity prices as reflecting broader global inflationary pressures. Rather than a symptom of abundant global liquidity—including through easy U.S. monetary policy—officials viewed the commodity price boom as reflecting a relative price shift in response to rapid growth in commodity intensive countries, such as China. While the global economy might be hitting some bottlenecks, there was little sign of generalized pressures on resources. Rather, fast productivity growth in emerging markets had limited cost increases of their products and the ability of producers elsewhere to pass through higher commodity prices.

21. The mission suggested that the present conjuncture seemed propitious for the Fed to define its inflation objective more explicitly. Fed officials responded that a committee headed by Vice-Chairman Kohn had been established to examine the Fed’s overall communication policy, including refining the definition of stable prices. Before such a refinement could occur, however, it would be necessary to establish a consensus that, by lowering inflation uncertainty, such a move would also be helpful in achieving the other objectives defined in the Federal Reserve Act (maximum employment and moderate long-term interest rates). Staff also suggested it could be helpful to increase the frequency and forward-looking element of the biannual Monetary Policy Report, to which officials responded that it would be difficult given the size and diversity of the FOMC.

III. Preserving Domestic and External Financial Stability

A. How Long Will Benign Financing Conditions Continue?

22. Discussions of financial sector developments centered on the implications of the rapid pace of change in the structure of U.S. financial markets (Figure 7). Officials observed that low credit spreads partly reflected the effectiveness of securitization and credit risk transfer techniques for improving the pricing and allocation of credit risk, especially for asset classes with higher risk profiles.7 The increased activity of hedge funds had enhanced price discovery and liquidity in many of the new markets. However, they agreed with the mission that some markets had yet to be fully tested in a less benign financial environment.

Figure 7.
Figure 7.

Financial Market Trends

Citation: IMF Staff Country Reports 2006, 279; 10.5089/9781451839661.002.A001

Sources: Haver Analytics; J.P. Morgan; Bank for International Settlements; Securities Industry Association; Moody’s Investor Services; Merrill Lynch; Pension Benefit Guaranty Corporation; Datastream; and Fund staff calculations.1/ For a discussion of distance-to-default measures, see Chapter 6 of United States: Selected Issues (IMF Country Report 04/228).

23. Officials observed that banks had been remarkably adept in responding to changing market conditions. Although banking margins had been squeezed by the flattening of the yield curve, profitability had been sustained by non-interest income and low charge-off rates, notwithstanding the impact of Hurricane Katrina and a spike in personal bankruptcies in late 2005 ahead of changes to the bankruptcy code. While bank revenues remained dependent on the real estate market, even small and regional banks had traded parts of their loan book against mortgage-backed securities, reducing their vulnerability to regional shocks.

24. Staff and officials agreed that a range of indicators suggested that systemic risks were at a low ebb (Figure 8):

  • Distance-to-default measures for “large complex banking groups” (LCBGs, discussed in more detail in Chapter 5 of the Selected Issues paper), the “big five” investment banks, and the insurance sector had recovered to levels last seen in the mid-1990s. Default risks were largely confined to declining industries (the auto and airline sectors are discussed in Chapter 6 of the Selected Issues paper).

  • Value-at-risk and implied default risk measures were low despite upticks after the May 2005 automotive industry rating downgrades and a large insurer’s admission of accounting in accuracies in late 2004.

  • Capital adequacy remained strong across the banking sector, reflecting high profitability in recent years.

Figure 8.
Figure 8.

Financial Sector Soundness Indicators

Citation: IMF Staff Country Reports 2006, 279; 10.5089/9781451839661.002.A001

Sources: Bankscope; Datastream; Bloomberg L.P.; and Fund staff estimates.1/ Value-at-Risk without market effects for portfolio of equities issued by subset of banks, in percent.2/ For a discussion of distance-to-default measures, see Chapter 6 of United States: Selected Issues (IMF Country Report 04/228).

25. Staff and officials agreed, however, that increased risk-taking could foreshadow some deterioration in credit quality. U.S. corporate credit markets remained strong, supported by sustained brisk earnings growth, and credit spreads were low. However, staff observed that ample liquidity had begun to facilitate a pickup in mergers and acquisitions as well as leveraged buyout activity, while easier bank lending conditions had allowed loan leverage ratios to rise to levels last experienced in 1997. These trends could signal a turn in the credit cycle, leading to increased market volatility and widening corporate credit spreads. Subsequent to the discussions, a rise in equity market volatility in May and June was accompanied by a global sell-off of riskier assets, although the impact on corporate bond spreads has been modest.

26. Financial sector risks related to household borrowing appeared relatively manageable. With bank exposures increasingly concentrated in the household sector, officials felt that recent regulatory guidance tightening standards for home equity lending and nontraditional mortgages had already led to tighter credit conditions in those markets. Moreover, stress tests indicated that borrowers at risk of significant mortgage payment increases remained a small minority, concentrated mostly among higher-income households that were aware of the attendant risks. Officials acknowledged, however, that for banks with high concentrations of commercial real estate and construction loans on their books, sustaining revenues in the case of a downturn could be difficult. Staff observed that there was a risk of a significant dent in banking profitability if the housing market slowed abruptly.

27. Officials acknowledged that regulators were facing a challenge to respond to the rapid evolution of the financial system. They emphasized that—with markets becoming more complex and decentralized—supervisors could no longer track risk exposures on a system-wide basis, but instead needed to ensure that controls and procedures at systemically important institutions and infrastructure providers were robust. Given the increasingly complex structure of bank’s operations, traditional supervisory activities were being augmented by a stronger analytical focus on large banks and critical market segments.

28. Specific regulatory issues covered during the discussions included:

  • Hedge funds. Fed officials noted that leverage and concentration indicators of hedge funds had moderated, and that their trading strategies were more diverse than in the period leading up to the LTCM crisis. The mission broadly agreed with their view that hedge fund market activities were too fluid for direct regulation to be effective, and that supervisors—both in the United States and abroad—needed to focus instead on measures to limit counterparty risk to banks acting as prime brokers and to continue to improve the financial infrastructure.8

  • Government-sponsored enterprises (GSEs). Staff and Treasury officials agreed on the need for rules to reduce the size of GSEs’ own portfolios given the systemic risks they posed to the financial system. Officials were cautiously optimistic that the Administration’s proposals to create a new regulator, establish risk-based capital requirements, and limit GSEs’ portfolios would gain congressional support in 2006. Using the Treasury’s ability to limit GSE debt issuance remained a second-best alternative, as it could encourage these institutions to accept greater risks to maintain profitability.

  • Basel II. Bank regulators expected some decline in minimum capital requirements after the shift to Basel II norms in 2009. They acknowledged that the impact on bank balance sheets was uncertain, in part because the role of the economic cycle would only become fully evident after the system was implemented. However, capital adequacy standards could be recalibrated, if necessary, as the transition to the new framework was to take place over several years.

  • Insurance regulation. Officials observed that the Administration had recently flagged the need for a stronger federal role in insurance regulation, which was presently a state responsibility. Staff supported this suggestion given the sector’s systemic importance, increasing globalization, and the potential for regulatory arbitrage across jurisdictions. Officials noted that similar considerations could argue for some consolidation in the regulation of some segments of the financial sector (including banks), although specific proposals were not under consideration.

  • Industrial Loan Companies (ILCs). Federal Reserve officials reiterated their concern that large commercial firms owning ILCs—some of which had evolved into sophisticated financial institutions—were not subject to consolidated supervision provisions under the Bank Holding Company Act. To protect the principle of consolidated supervision over banking operations, the mission agreed that ILCs should be limited in their ability to establish nationwide branch networks.

29. The mission suggested that a Fund Financial Sector Assessment Program (FSAP) might be a useful vehicle for providing an international perspective on these issues. Treasury and Fed officials responded that they were open to participating in an FSAP, and indicated interest in discussing specific modalities. The team also asked whether publishing a Financial Stability Report—as prepared by many other central banks or financial sector supervisors—might improve the market’s understanding of U.S. financial risks and vulnerabilities. Fed officials responded that such a report would not add much value to what was already being published by regulators and market participants.

30. The team welcomed Administration proposals to strengthen defined benefit (DB) plans. Officials explained that current workers seemed to be accumulating retirement assets at a pace comparable to previous generations but, given the unfunded liabilities of many DB plans and the Social Security system, maintaining living standards past retirement could become more challenging. Proposals included reducing disincentives for overfunding of plans, using corporate bond yields to calculate pension liabilities, and allowing the Public Benefit Guaranty Corporation (PBGC) to set risk-based premiums. On the accounting side, officials were confident that a pending proposal by the Financial Accounting Standards Board (FASB) to include pension accounts in corporate balance sheets would lead to greater transparency and could help improve plan funding.

31. Staff and officials agreed that automatic enrollment in employer sponsored defined contribution plans with rising contribution schedules could help boost personal saving. Officials were seeking to amend pension regulations so that workers could be automatically enrolled in such plans, but legislation might be required to protect employers from legal sanctions that might arise if the return on pension investments disappointed. Officials observed that tax incentives, such as the lifetime saving accounts (LSAs) proposed in the budget, could also stimulate personal saving, but acknowledged that the net impact on national saving might be small in the absence of offsetting deficit-reduction measures.

B. How Will the Current Account Deficit Adjust?

32. The current account widened to a record 6¼ percent of GDP in 2005, owing to higher oil prices and the relative strength of U.S. import demand (Figure 9 and Tables 3 and 4). In addition, staff analysis suggests that the shift in U.S. trade toward low-cost producers had blunted some of the measured real effective exchange rate depreciation in recent years (Figure 10 and Box 2 in last year’s Staff Report). Nonetheless, the U.S. net foreign liability (NFL) position barely deteriorated in 2005, reflecting the effects of the relative strength of foreign equity markets on U.S. residents’ investments, although recent financial market developments may have reversed some of these gains.

Figure 9.
Figure 9.

External Developments

Citation: IMF Staff Country Reports 2006, 279; 10.5089/9781451839661.002.A001

Sources: Haver Analytics; International Financial Statistics; Lane and Milesi-Ferreti (2006); and Fund staff estimates.1/ China, Hong Kong SAR, Indonesia, Korea, Malaysia, the Philippines, Singapore, Taiwan Province of China, and Thailand.2/ Algeria, Angola, Azerbaijan, Bahrain, Republic of Congo, Ecuador, Equatorial Guinea, Gabon, I.R. of Iran, Kuwait, Libya, Nigeria, Norway, Oman, Qatar, Russia, Saudi Arabia, Syrian Arab Republic, Turkmenistan, United Arab Emirates, Venezuela, and the Republic of Yemen.
Table 3.

Balance of Payments

(Billions of U.S. dollars, unless otherwise indicated)

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Source: Haver Analytics.
Table 4.

Indicators of External and Financial Vulnerability

(In percent of GDP, unless otherwise indicated)

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Sources: IMF, International Financial Statistics; Federal Deposit Insurance Corporation; and Haver Analytics.

With FDI at market value.

Excludes foreign private holdings of U.S. government securities other than Treasuries.

External interest payments: income payments on foreign-owned assets (other private payments plus U.S. government payments).

FDIC-insured commercial banks.

Noncurrent loans and leases.

Figure 10.
Figure 10.

Indicators of International Competitiveness

Citation: IMF Staff Country Reports 2006, 279; 10.5089/9781451839661.002.A001

Sources: Haver Analytics; IMF, World Economic Outlook; and Fund staff calculations.1/ Trade-weighted index using deviations from PPP to measure competitiveness.

U.S. Spillovers to the Rest of the World

With the world’s largest economy and most dominant financial markets, the U.S. has large significant spillovers on other countries:

  • Real activity. Past WEO forecast errors (available since 1990) suggest that an unanticipated 1 percent undershoot in U.S. growth is associated with a ¼ percent slowing in growth elsewhere, with the largest effects being on countries with close trade and financial links. This may underestimate the effect of U.S. growth on the rest of the world, given the possible offsets provided by large non-U.S. shocks in the 1990s—such as the Asian crisis and German unification.

  • Financial markets. U.S. financial markets retain their global dominance, for example dollar assets represent about half of global private sector bonds. Recent studies find that shocks to U.S. long-term real interest rates continue to flow through to foreign rates, including to major regions such as the euro area, and emerging market bond spreads appear particularly closely linked to U.S. financial conditions (see Box 1.5 of the April 2006 Global Financial Stability Report). In addition, rising gross international investment positions have increased the potential for wealth spillovers from changes in the dollar and U.S. asset prices (Annex II. 4). Finally, U.S. financial market conditions have a direct impact on countries that link their exchange rates to the U.S. dollar.

  • External indebtedness. Most analysts agree that while the size of U.S. net international liabilities are not currently a concern they are growing at an unsustainable rate. While many see a significant—and possibly abrupt—adjustment of the dollar as being necessary to correct this trend, with attendant risks for global growth and financial stability (as discussed in the World Economic Outlook), others have suggested that the resolution could come through a gradual adjustment of global saving and investment balances with more limited impacts on exchange rates.

United States: Spillover Effects of Unanticipated

U.S. Growth on the Rest of the World and Key Trading Partners, 1990-2005 1/

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Source: Fund staff calculations

Values indicate the empirical relationship (slope coefficient) between U.S. growth forecast error and a given country’s growth forecast error.

Estimated over 1998-2005, to exclude the effects of the Tequila crisis.

Median of France, Germany, and Italy.

U.S. monetary and fiscal policies also have international spillovers although the size of their impact remains a subject of controversy. Global Financial Stability Reports have discussed how abundant international liquidity—partly reflecting the stance of the Fed—has put downward pressure on global bond yields and supported a search for yield. In addition, analysis in the World Economic Outlook and elsewhere has estimated the impact of U.S. fiscal deficits on U.S. and global saving, external imbalances, and global real interest rates.

U.S. policies often matter more for other countries than domestically. A good example of this is the proposal by the President’s Tax Reform commission to move from taxing worldwide corporate earning to a territorial system, which has generated almost no discussion at home but could significantly increase global tax competition. Staff analysis of this subject is discussed in Annex II. 5.

33. Officials agreed that the current account deficit seemed likely to widen further. Although the pickup in activity in Europe and Japan would support the trade balance, the large gap between exports and imports meant that exports needed to grow almost twice as fast as imports simply to keep the deficit unchanged. This could be difficult to achieve given that most estimates placed the income elasticity of U.S. imports as up to double the size of that for exports. Growing foreign indebtedness and rising U.S. interest rates also meant that debt dynamics were adverse, with the investment balance expected to turn negative in 2006.

34. The staff noted that the real exchange rate appeared significantly overvalued, especially given the projected deterioration of U.S. net foreign liabilities (see Annex III). A staff assessment using macroeconomic fundamentals estimated the overvaluation in the 15-35 percent range. Officials cautioned that such estimates were highly sensitive to underlying assumptions, markets were best placed to judge appropriate exchange rate levels, and foreign investors showed no signs of becoming less willing to invest in U.S. markets. In this context, they expressed concern that exchange rate inflexibility and other factors were impeding needed adjustment in many countries’ competitiveness.

35. Officials remained relatively sanguine about the risk of a disorderly adjustment. U.S. financial markets were well placed to intermediate global savings, and recent dollar strength implied that the demand for U.S. securities was not satiated.9 Staff noted that market expectations implied a relative sanguine view of the risks of future dollar weakness (background work, summarized in Annex II. 3, finds dollar risk premiums have varied widely over time but have not consistently risen with the increase in net foreign liabilities). Officials responded that, although sharp exchange rate adjustments could not be ruled out, experience suggested that markets could absorb considerable exchange rate movements, particularly since national financial systems had become more resilient.

36. The mission cautioned about the risks of a “disorderly” resolution of imbalances, emphasizing the need for a cooperative global adjustment strategy. This underscored the importance of raising U.S. national saving, including by more ambitious fiscal consolidation, in conjunction with steps toward greater exchange rate flexibility in emerging Asia and continued structural reforms to boost growth in Europe and Japan. Extensive analysis in the World Economic Outlook and elsewhere indicated that a disorderly resolution could significantly lower growth in the United States and abroad (Box 2).10 Annex II. 4 summarizes background work suggesting that wealth losses to foreign investors from a drop in U.S. asset prices and the value of the dollar could be significant.

37. Officials agreed that the solution to global imbalances would require a multilateral approach. They expressed strong support for the Fund’s leadership in the multilateral consultations process, and hoped that this would increase the understanding of the shared responsibility for addressing the situation. Officials were concerned that surplus countries had not accepted the need to boost domestic demand relative to output and cautioned that, without such an understanding, efforts to boost U.S. national saving—including through fiscal deficit reduction—would likely have a modest impact on global imbalances but could slow global growth. They also stressed that increased financial globalization argued against pursuing international exchange rate agreements, such as those contained in the 1985 Plaza Accord.

IV. Fiscal Policy: Preparing for an Aging Population

A. The Long-Term Challenge

38. Staff and Treasury officials agreed that the long-term fiscal outlook was unsustainable and that entitlement reform was needed (Figure 11). Population aging and rising health care costs are projected to place an ever increasing burden on public retirement and health systems in the United States, as it is in other OECD countries (Figure 12). The FY 2007 budget projects that spending on entitlement programs (including Social Security and Medicare) will rise by around 1½ percent of GDP each decade through 2080. With contributions to these programs expected to grow much less rapidly:

  • The Trustees currently estimate the 75-year funding gap of the Social Security and Medicare systems at 325 percent of GDP. The Social Security system—which presently runs a cash surplus of 1½ percent of GDP—is projected to fall into deficit as early as 2017. The underfunding of the Medicare system is much larger, and has been increased by 80 percent of GDP by the prescription drug benefit.

  • Medicaid—the federal and state program providing health coverage for the poor and disabled—also has a large implicit funding gap. The rapid increase in outlays would make it increasingly difficult for states to meet their balanced-budget requirements without spending cuts elsewhere, increased tax revenues, or higher federal transfers.

  • Social Security reforms have stalled in Congress. The Administration has proposed establishing a bipartisan commission to examine broad reform of entitlement programs, but there has been little subsequent progress. Greater consensus was needed in Congress to carry the process forward.

Figure 11.
Figure 11.

Fiscal Indicators

Citation: IMF Staff Country Reports 2006, 279; 10.5089/9781451839661.002.A001

Sources: Haver Analytics; OECD; Social Security and Medicare Boards of Trustees; Congressional Budget Office (CBO); Office of Management and Budget; and Fund staff calculations.1/ The three paths are based on differing demographic assumptions.2/ CBO projections, December, 2005.
Figure 12.
Figure 12.

Fiscal Indicators in an International Setting

Citation: IMF Staff Country Reports 2006, 279; 10.5089/9781451839661.002.A001

Sources: OECD; and IMF, World Economic Outlook.

B. Medium-Term Budget Policy

39. Officials emphasized that recent revenue buoyancy and expenditure discipline had improved fiscal prospects (Table 5). Tax receipts through April (which included annual personal tax filings for 2005) exceeded projections on both the personal and corporate side by a significant margin. The reasons for revenue overperformance were still not fully understood, but all indications were that this year’s deficit would fall below 2½ percent of GDP, well under the budget projection of 3¼ percent. As a result, the objective of “halving the deficit”—relative to the $540 billion (4½ percent of GDP) that had been forecast for FY2005—now seemed likely to be met by FY 2008, a year ahead of schedule.

Table 5.

Fiscal Indicators

(Fiscal years; in percent of GDP except where otherwise indicated)

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Sources: FY 2007 Budget of the U.S. Government (February 6, 2006); and Fund staff estimates.

Staff projections are based on the Administration’s budget adjusted for differences in macroeconomic projections; staff estimates of the cost of ongoing operations in Iraq; some additional non-defense discretionary expenditure; and continued AMT relief beyond FY2007. The projections also assume that PRA’s are not introduced.

As a percent of potential GDP, based on proposed measures, under IMF staff’s economic assumptions.

On a national accounts basis. The projections use Fund staff budget and economic assumptions.