United States
2008 Article IV Consultation: Staff Report; Staff Supplement; and Public Information Notice on the Executive Board Discussion
Author: International Monetary Fund
Publication Date:
30 Jul 2008
eISBN:
9781451839715
Language:
English
Keywords:
monetary policy; bond market; inflation expectation; house price; discount window; credit crunch
Download PDF (1.7 MB)

This 2008 Article IV Consultation highlights that problems in the housing and financial markets over the past year have combined to slow the United States’ economy substantially. As the residential investment downturn accelerated and national indices of housing prices started falling, mortgage defaults rose sharply, and bank losses mounted. Policymakers have responded aggressively to these developments. IMF staff analysis suggests that the dollar is closer to its medium-term equilibrium level, although still on the strong side.

Abstract

This 2008 Article IV Consultation highlights that problems in the housing and financial markets over the past year have combined to slow the United States’ economy substantially. As the residential investment downturn accelerated and national indices of housing prices started falling, mortgage defaults rose sharply, and bank losses mounted. Policymakers have responded aggressively to these developments. IMF staff analysis suggests that the dollar is closer to its medium-term equilibrium level, although still on the strong side.

I. Background

1. Growth has slowed dramatically, as many of the downside risks to the U.S. economy outlined in last year’s staff report have materialized (Figure 1). The impact of the housing downturn, limited to the construction sector a year ago, has since fed through to household spending and financial markets, further slowing GDP growth. Payrolls have shrunk for five months in a row (somewhat sharper declines have reliably signaled past recessions), the unemployment rate has risen, and, despite some recent easing, financial market conditions remain strained. More recently, the latest surge in food and energy prices has lifted headline inflation, constraining monetary policy options and partly offsetting temporary boosts to disposable income and consumption from fiscal stimulus.

Figure 1.
Figure 1.

United States: Recent Indicators

Citation: IMF Staff Country Reports 2008, 255; 10.5089/9781451839715.002.A001

Sources: Haver Analytics; and Fund staff calculations.
uA01fig01

Employment and Recessions

Citation: IMF Staff Country Reports 2008, 255; 10.5089/9781451839715.002.A001

Sources: Federal Reserve Bank of St. Louis; Haver Analytics; and Fund staff calculations.

2. The economy is in uncharted waters, with house prices falling nationwide for the first time in at least four decades (Figure 2). From 2001, rising housing values boosted wealth, spending, and mortgage borrowing. At some point, entrenched expectations of house price rises led to a self-reinforcing process of imprudent lending by financial institutions to willing—and at times misled—borrowers. Stretched bank balance sheets were masked as additional lending occurred mainly through lightly-capitalized entities. Final investors underestimated risks to asset quality, reflecting over reliance on lax credit ratings and on the stability of geographically-diversified U.S. mortgage pools. The full implications of these individual trends, exposed once house-price appreciation reversed, were missed by most commentators, including the Fund.

Figure 2.
Figure 2.

United States: Anatomy of a Housing Boom and Bust

Citation: IMF Staff Country Reports 2008, 255; 10.5089/9781451839715.002.A001

Sources: Haver Analytics; Merrill Lynch; Intex; and Fund staff calculations.
uA01fig02

House Prices

Citation: IMF Staff Country Reports 2008, 255; 10.5089/9781451839715.002.A001

Sources: Haver Analytics; Bloomberg, L.P.; and Fund staff calculations.1/ Illiquidity in market may lend a downward bias to prices implied by futures contracts.

3. Financial supervision and regulation, more than monetary policy, failed to rein in lending excesses, the reversal of which is reverberating around the world. With the U.S. economy recovering slowly from the 2001 recession, the Fed delayed raising policy rates until 2004, boosting spending and—through a relatively steep yield curve—prompting a major switch to adjustable rate mortgages (ARMs). While the eventual rate increase slowed most parts of final demand, the housing boom, fueled by low initial (“teaser”) mortgage interest rates, continued to boost construction and hold down household savings. Importantly, a fragmented regulatory system did not recognize the implications of the financial system becoming over-leveraged, while outdated rules failed to constrain imprudent mortgage lending. Delinquency and foreclosure rates are now rising on all ARMs, particularly subprime ones, but banks face more widespread problems. Higher spreads and a slowing economy are exposing other underwriting lapses—e.g., in auto, credit card, and commercial real estate loans. Elevated spreads in money and bond markets have been transmitted to financial centers around the world, reflecting the central role of the United States in the global financial system (Box 1). As a result, growth is now slowing in many industrial countries, although it has so far remained robust in emerging markets.

4. Despite slowing growth, headline inflation has been pushed up by energy and food prices, raising fears that thus-far anchored inflation expectations will drift up. At slightly over 4 percent, headline CPI inflation is again around the highs of mid-2005 to mid-2006. By contrast, the Fed’s preferred measure of trends—core personal consumption expenditure inflation—remains just above their presumed comfort zone of 1–2 percent, with no evidence of higher energy costs spilling over on other prices. While there are signs that short-term inflation expectations are rising, medium-term expectations appear better anchored, and wages continue to slow in line with a weakening labor market.

uA01fig03

Inflation Expectations

Citation: IMF Staff Country Reports 2008, 255; 10.5089/9781451839715.002.A001

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

II. Balance Sheet Strains

A. Housing and Households

5. After an unsustainable run up, house prices are now falling sharply across the country. With the dispersion of house price changes tightening progressively, it is clear that the housing boom and bust is a national phenomenon, even if some areas have been harder hit. House-price inflation at the national level peaked in 2005, and prices are now declining. Office of Federal Housing Enterprise Oversight (OFHEO) purchase-only prices, which have a wide geographic coverage but include only safer (conforming) mortgages, peaked in April 2007 and have fallen 4½ percent to date. By contrast, the Case-Shiller 10-city index, which covers only major urban areas but all types of sales (including those financed by subprime and jumbo loans) started to fall in mid-2006 and is already 18 percent below its peak. On the latter measure, prices fell by almost 10 percent from December through April and futures markets project a further 15–20 percent fall, suggesting continuing strong pressure on house prices, especially in previously hot markets such as California and Florida.

uA01fig04

Regional House Price Cycles

Citation: IMF Staff Country Reports 2008, 255; 10.5089/9781451839715.002.A001

Source: Haver Analytics.

International Spillovers

The tightening in U.S. financial conditions has been transmitted rapidly abroad. Global money market premiums, bond market spreads, and equity risk premiums have moved in tandem with their U.S. analogues. With estimated aggregate losses of European banks similar to their U.S. counterparts, lending standards have risen significantly in Europe and, to a somewhat lesser extent, in Japan.

The current U.S. slowdown is likely to result in significant aftershocks in other industrial countries. The size of the U.S. economy and dominance of its financial markets create international spillovers through trade, commodity prices, and global financial markets. Desk analysis suggests that a 1 percent fall in U.S. activity gradually lowers real GDP in other industrial countries by some ½ percent after a year or so. The bulk of this effect comes through financial linkages, with smaller effects through trade and commodity prices.

While slowing activity and dollar depreciation are curbing U.S. imports, buoyant commodity prices are supporting activity in producer countries. Trade links are strongest for NAFTA partners—Canada and Mexico—whose economies are highly dependent on U.S. activity, especially manufacturing, while support from commodity prices is more important in other cases.

A number of countries with pegs or limited flexibility against the dollar are finding that they are importing a more relaxed monetary stance than is appropriate for them. These countries, which are already facing considerable inflationary pressure, would in the normal course have sought to raise interest rates but have only limited room to do so, given their exchange rate regimes.

uA01fig05

Lending Standards for Large Firms

Citation: IMF Staff Country Reports 2008, 255; 10.5089/9781451839715.002.A001

uA01fig06

Spillovers of U.S. Economic Activity

Citation: IMF Staff Country Reports 2008, 255; 10.5089/9781451839715.002.A001

1/ Includes Australia, Canada, Denmark, Korea, Mexico, New Zealand, Norway, South Africa, Sweden, Switzerland, Taiwan P.O.C., and United Kingdom.

6. Falling house prices could be taking on a life of their own, as the supply overhang is exacerbated by reduced incentives to buy and higher foreclosures. While the size and sources of pressure on house prices vary by region, staff background analysis suggests that the inventory-sales ratio and foreclosure starts are good predictors of national house price movements, with the gap between current and estimated equilibrium prices playing only a limited role (Selected Issues, Chapter 1). In fact, expectations of further price declines and credit constraints are choking sales (as buyers wait for lower prices), while a rising wave of foreclosures is adding inventory and diminishing values of neighboring houses (each foreclosure is estimated to lower the prices of other homes within one-eighth of a mile by 1 percent).

7. With housing assets and mortgage debt at near-record ratios to disposable income, household balance sheets are particularly exposed to house-price declines. The staff baseline forecast assumes that nominal prices will fall a further 10 percent on an OFHEO basis and somewhat more using Case-Shiller indices. In real terms (OFHEO basis), house prices fall from their current level of 10 percent or so above equilibrium to 5 percent or more below equilibrium by end-2009. The resulting peak-to-trough reduction in net household wealth and collateral of almost 30 percent of GDP puts considerable downward pressure on consumption: each dollar fall in wealth is expected to reduce consumption by 7 cents, with about half the reduction in the first year. This is at the upper end of estimated wealth and collateral effects, reflecting borrowers’ growing access to home equity over time.

uA01fig07

Household Wealth

Citation: IMF Staff Country Reports 2008, 255; 10.5089/9781451839715.002.A001

Source: Haver Analytics.

8. Spending has weakened on eroding wealth, declining employment, high oil prices, and credit constraints (Figure 3). Employment has fallen by ¼ percent since December even as food and energy hikes have boosted prices by almost one percent. These pressures on real incomes, along with financial strains, are eroding consumer confidence, with some measures down to levels last seen in the early 1980s. As a result, real consumption, which accounts for 70 percent of GDP, slowed to a crawl in early 2008 (versus a trend growth rate of 3½ percent a year over the last decade). Consumption jumped in May and likely stayed high in June, reflecting the temporary stimulus from tax rebates that raised disposable incomes by around 5 percent in May–June.

Figure 3.
Figure 3.

United States: Household Cash Flow and Balance Sheets

Citation: IMF Staff Country Reports 2008, 255; 10.5089/9781451839715.002.A001

Sources: Mortgage Bankers Association; Bloomberg; Equifax, Moody’s Economy.com; and Haver Analytics.

B. Financial Intermediaries

9. The shock to U.S. financial markets hit an overleveraged system dependent on market liquidity (Figure 4). The asset boom from mid-2004 to mid-2007 came mainly from highly leveraged investment banks and off-balance sheet affiliates of commercial banks (conduits and special investment vehicles). Regulators underestimated the degree to which tangible capital had become stretched, in part because of an under-appreciation of the importance to banks of supporting off-balance sheet affiliates for reputational reasons when financing conditions deteriorated. While the limited capital backing for the apparent “originate-to-distribute” boom was sustainable when markets were liquid and the price of risk low, investors are now shunning complex asset-backed securities, tightening investment criteria, and forcing the system back to a more overt “originate-to-hold” mode. In essence, there has been a rapid and involuntary return to intermediation through bank balance sheets.

Figure 4.
Figure 4.

United States: The Banking Sector Leverage Cycle

Citation: IMF Staff Country Reports 2008, 255; 10.5089/9781451839715.002.A001

Sources: Merrill Lynch; Haver Analytics; Bank reports; Bloomberg, L.P.; and Fund staff calculations.1/ BHCs and IBs are those listed in table. Leverage is assets as a percent of equity.2/ Excludes 2004.
uA0afig08

The Asset Boom

Citation: IMF Staff Country Reports 2008, 255; 10.5089/9781451839715.002.A001

Sources: Haver Analytics; and Fund staff calculations.

10. Loan losses add to the need for more capital to support overextended balance sheets. Estimates from the Spring 2008 Global Financial Stability Report, using prevailing market prices, put losses at near $1 trillion globally and $220–260 billion for U.S. banks—over one-third of the equity of the ten major commercial and investment banking groups. Of this, some $160 billion in U.S. losses have already been recognized, reflecting deep discounts on assets such as mortgage-backed collateralized debt obligations previously believed to be secure. If illiquidity has pushed market prices well below underlying values, realized losses could be smaller than priced in, and the financial sector could stabilize faster than projected. However, with house prices falling and the credit cycle tending to lag the slowdown in activity, bank losses could just as likely overshoot current market assumptions.

11. Reflecting their high leverage and reliance on wholesale funding, pressures have been heaviest on the largest banks. Liquidity problems initially stemmed from uncertainty about the location of losses and short-term funding needs and, with collateral requirements tightening, lenders started shunning weaker institutions. In early March, the Fed facilitated the acquisition of Bear Stearns by JPMorgan Chase after it experienced a wholesale funding run, with access to even secured borrowing against high-quality collateral drying up. Immediately afterwards, the Fed widened its discount window to the remaining primary dealers (including, importantly, major investment banks), which calmed systemic concerns and lowered credit default swap spreads of the major institutions. However, as observed by Chairman Bernanke, financial conditions remain far from normal. Credit default and interbank spreads remain high, suggesting continuing solvency/liquidity concerns.

12. In response to strains on capital, commercial and investment banks are tightening loan standards, cutting costs, and raising new equity. The Fed’s Senior Loan Officer Opinion Survey—a strong predictor of future activity—suggests that loan conditions are tightening at rates similar to those seen in the credit crunch of the early 1990s. With falling turnover constraining fee and trading income, the financial sector has shed almost 120,000 jobs since the beginning of 2007, canceled equity buybacks, and lowered dividends. Major U.S. banks have raised an impressive $125 billion in new capital, initially from sovereign wealth funds and now other investors. However, the size of continuing problems is illustrated by Citigroup’s announcement that it will divest a quarter of its assets ($500 billion) even after raising over $40 billion in new capital.

13. The financial system’s balance sheet shrank in the last quarter of 2007, for the first time since the credit crunch of the early 1990s (Figure 5). Contracting assets of nonbanks—mainly asset-backed security issuers and broker-dealers—more than offset a largely involuntary expansion in commercial bank loans as conduits were bailed out or absorbed and previously agreed lines of credit activated. While asset growth rebounded modestly in the first quarter of this year, slowing activity is reinforcing the underlying drivers of the credit crunch—deleveraging and mounting losses—and implying further strains on credit availability. Indeed, bank lending appears to have stalled in April and May.

Figure 5.
Figure 5.

United States: Deleveraging

Citation: IMF Staff Country Reports 2008, 255; 10.5089/9781451839715.002.A001

Sources: Haver Analytics; Bloomberg, L.P.; J.P. Morgan; Inside Mortgage Finance; and Fund staff calculations.
uA01fig09

Change in Financial Sector Assets

Citation: IMF Staff Country Reports 2008, 255; 10.5089/9781451839715.002.A001

Sources: Haver Analytics; and Fund staff calculations.

III. Macrofinancial Linkages

14. The major risk is that house prices fall well below equilibrium, generating self-reinforcing cycles and further macroeconomic disruption (Figure 6). Declines in house prices are increasing financial market stress directly through losses on mortgages and mortgage-backed securities, and indirectly through delinquencies as consumption and construction spending slows. Strains on bank capital are resulting in a rapid tightening of bank lending standards, which in turn are threatening to restrict access to mortgages, consumer credit, and new corporate loans—thus putting further downward pressure on spending, incomes, house prices, and wealth. Meanwhile, weak activity and rising defaults are keeping up credit spreads and depressing issuance of asset-backed securities.

Figure 6.
Figure 6.

United States: Macro-Financial Linkages

Citation: IMF Staff Country Reports 2008, 255; 10.5089/9781451839715.002.A001

Sources: Haver Analytics; Merrill Lynch; J.P. Morgan; Bloomberg, L.P.; and Fund staff calculations.

15. To assess these interactions, staff have developed two alternative tools to examine linkages between financial conditions and demand:

  • A financial conditions index analyzes the interaction between an array of financial indicators—short-term interest rates, bond spreads, equity prices, exchange rates, and, importantly, bank loan standards—and real GDP using vector autoregressions (Selected Issues Chapter 2). The model suggests that, despite Fed cuts and dollar depreciation, financial conditions have tightened since mid-2007 and will—given lags—slow growth by around 1¼ percentage points over the next year. In addition, staff expect some further tightening of financial conditions, including loan standards, which implies a further ¾ percentage point slowdown next year.

  • A banking model traces how strains on bank capital gradually feed through loan conditions to consumer, mortgage, and corporate lending, and hence to associated spending, as well as the reverse feedback from weaker spending and incomes to bank capital and lending (Selected Issues Chapter 3). This model suggests macrofinancial linkages—and hence an outlook—that is similar to that produced by the financial conditions index; a percentage point shock to the bank capital-asset ratio subtracts some 1–2 percent from the baseline path of GDP, with the maximum impact on growth after a year or so. The model can also be run in reverse, with credit and bank lending channels doubling the impact of an initial fall in spending/GDP and elongating the response.

uA01fig10

Growth and Financial Conditions

Citation: IMF Staff Country Reports 2008, 255; 10.5089/9781451839715.002.A001

Sources: Haver Analytics; and Fund staff calculations.
uA01fig11

Financial System Feedback Loop

Citation: IMF Staff Country Reports 2008, 255; 10.5089/9781451839715.002.A001

Source: Fund staff estimates.

16. Weak credit and household spending are hurting firms, but the impact is being cushioned by strong corporate balance sheets and external demand (Figure 7). With many firms holding substantial cash buffers, the path of business investment is expected to be driven primarily by the growth slowdown, although credit constraints are also playing a role. Equity prices have fallen most in the sectors under strongest pressure—finance, construction, and discretionary consumption—and background work using valuations of individual firms confirms that weakness is more pronounced in those more reliant on market borrowing and, to a lesser extent, household spending (Selected Issues, Chapter 4). However, staff analysis also finds that the proportion of firms in need of external financing has shrunk since the early 2000s. Further support, especially for manufacturing, is coming through external demand, which is being boosted by still-robust growth abroad and dollar weakness.

Figure 7.
Figure 7.

United States: Corporate Sector Cash Flow and Balance Sheets

Citation: IMF Staff Country Reports 2008, 255; 10.5089/9781451839715.002.A001

Sources: Consensus Forecasts; Datastream Advance, Haver Analytics; and Fund staff calculations.
uA01fig12

Corporate Balance Sheets

Citation: IMF Staff Country Reports 2008, 255; 10.5089/9781451839715.002.A001

Sources: Haver Analytics; and Fund staff calculations.

IV. The Resulting Outlook

17. While forward-looking indicators such as consumer confidence and lending standards suggest a decline in activity, so far final demand has continued to grow. With spending showing surprising resilience through the second quarter in the face of headwinds, the baseline staff forecast is for real GDP growth to be slightly positive in 2008 (Q4/Q4), followed by a gradual recovery. In the staff baseline, the weakness in real final domestic demand seen in the first quarter of 2008 continues through the year, as household and financial strains feed off each other, although stimulus supports growth in the late spring/summer (Figure 8). Inflation falls gradually as commodity prices peak and slack dampens wage pressures. Real net exports boost output by 1 percent of GDP on slowing domestic activity, continuing strong growth in emerging markets, and competitiveness gains from past exchange rate depreciation.

Figure 8.
Figure 8.

United States: Outlook and Risks

Citation: IMF Staff Country Reports 2008, 255; 10.5089/9781451839715.002.A001

Sources: Haver Analytics; IMF, World Economic Outlook, April 2003; and Fund staff calculations.

Assumptions Behind the Outlook

(In percent; annual average terms)

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United States: Short-Term Projections

(Percent change from previous period, unless otherwise indicated)

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Sources: Haver Analytics; Consensus Forecasts; Federal Reserve Board; and Fund staff estimates.

18. The slow recovery, relative to the consensus forecast, reflects the impact on households of the credit crunch and falling wealth. The current episode is in contrast to previous downturns, where business spending was the key driver of the cycle. Households have fewer ways to respond to financial and collateral strains than firms—staff analysis suggests that consumption is much more dependent on access to bank lending and collateral than is business investment. With falling house prices reducing collateral for personal borrowing even as losses tighten bank lending standards, credit constraints are likely to build gradually, and household spending and income growth are projected to remain relatively sluggish through the first half of 2009. Thus, the eventual recovery is slower than is typical of the United States but faster than suggested by international and U.S. regional evidence on housing busts (Selected Issues, Chapter 5), reflecting economic flexibility, the rapid policy response, and support from external demand. The consensus forecast, by contrast, sees a much more typical V-shaped recovery starting in the second half of this year as fiscal and monetary stimulus kicks in.

uA01fig13

Real GDP in Downturns and Recoveries

Citation: IMF Staff Country Reports 2008, 255; 10.5089/9781451839715.002.A001

uA01fig14

Recoveries from U.S. Regional Housing Busts

Citation: IMF Staff Country Reports 2008, 255; 10.5089/9781451839715.002.A001

19. Potential deviations from this path are large, given the unprecedented nature of the shocks. While risks to growth are balanced, those for inflation are modestly to the upside, reflecting uncertainties about commodity prices and passthrough. With spending surprisingly resilient even as forward-looking indicators such as weakening consumer confidence and tightening bank lending standards, the range of plausible outcomes is extremely wide, as shown in the fan charts of potential outcomes (Figure 8). Upside and downside scenarios approximating the tenth and ninetieth percentiles of possible outcomes illustrate the main uncertainties:

  • On the downside. More extended financial system pressures could generate a longer and sharper credit crunch, as weak credit and activity feed back into further bank losses. The prolonged slowing of industrial country activity starts spilling over to the rest of the world, reducing the external support to demand. The result is the type of extended slowdown and pallid recovery seen in “typical” housing busts elsewhere. Extended financial sector difficulties imply a larger role for the cycle in explaining recent high growth, and hence some downward revision in potential growth.

  • On the upside. By contrast, a rapid recapitalization of the financial sector, policy stimulus, and robust global activity could yield a V-shaped recovery of the type embodied in consensus forecasts. Smaller downdrafts to consumers from credit and housing strains are offset by fiscal and monetary stimulus. A recovery starting in the second half of 2008 causes growth to overshoot its potential rate in mid-2009 before settling back as the Fed rapidly tightens to combat inflationary pressures.

uA01fig15

Real GDP scenarios

Citation: IMF Staff Country Reports 2008, 255; 10.5089/9781451839715.002.A001

20. The authorities expect an outcome more similar to the staff’s upside scenario than the baseline path. There was agreement about the qualitative factors that have been shaping the economy’s path, but the authorities consider the baseline’s financial and housing conditions overly pessimistic. In particular, Treasury officials emphasize the flexible and diversified nature of the U.S. economy, and the support to activity from strong corporate balance sheets, external demand, and macroeconomic stimulus—which they expect to help the economy recover in the second half of 2008. These different views shaped the policy discussions.

V. Macroeconomic Policy Responses

A. Monetary Accommodation

21. Having eased rapidly, monetary policy settings are now consistent with a robust response to downside risks to growth (Figure 9). From mid-2006 through late 2007 Fed policy was mildly restrictive as core inflation remained above the upper end of its implicit comfort zone, mainly reflecting delayed increases in owner-equivalent rent, which had stayed remarkably low during the housing boom. The Fed subsequently responded rapidly to recessionary risks cutting rates by 325 basis points in less than five months. The real federal funds rate is now below zero (even using core CPI inflation), as well as below settings implied by standard Taylor rules, although the impact is being dampened by widening spreads and tighter lending standards. In addition, a relatively flat bank-yield curve is limiting the support from low policy rates to banks’ profits from maturity transformation.

Figure 9.
Figure 9.

United States: Monetary Policy Indicators

Citation: IMF Staff Country Reports 2008, 255; 10.5089/9781451839715.002.A001

Sources: Haver Analytics; Board of Governors of the Federal Reserve System; and Fund staff calculations.

22. While inflation concerns are on the rise, the staff forecast of further economic weakness and a slow recovery suggest that policy should remain on hold. Concerns about activity would need to be much more pronounced to justify a more accommodative stance. On the other hand, although surging commodity prices have lifted headline inflation and near-term expectations, medium-term inflation expectations have remained relatively anchored, while wages and unit labor costs are slowing with activity. The case for a preemptive hike in policy rates, as markets now anticipate, is therefore unclear. That said, given the costs of reversing high expectations once they become entrenched, policy will need to be especially alert to the possible need to withdraw stimulus quickly as the economic recovery gains traction.

23. U.S. biofuels subsidies added to the boom in corn and soybean prices, but the role of monetary policy in the recent commodity surge is more controversial. With high fuel prices providing strong incentives to produce biofuels, the subsidy has become in essence a simple transfer to producers, and staff see a suspension as sensible. U.S. officials do not think that subsidies have contributed much to food inflation and pointed out that suspension would anyway be difficult, since Congress deleted a proposed safety valve clause that would have allowed such adjustment. On monetary policy, as discussed in the April World Economic Outlook, staff analysis suggests that lower U.S. interest rates and a weaker dollar are playing a significant role in surging world commodity prices. Fed officials, however, are skeptical about such an impact of monetary policy, noting that there is little evidence of a rise in commodity inventories or of a stable relationship between commodity prices and real interest rates.

24. In the wake of the housing bubble, the role of asset prices in monetary policy bears reexamination. In staff’s view, it remains doubtful that policymakers can identify unsustainable asset price booms with sufficient confidence to justify strong offsetting interest rate moves. However, the fact of two asset-price busts in this decade with prolonged macroeconomic consequences underlines the dangers of inaction. Thus, given the potential for asset booms to turn into economic busts and lead to a rapid loosening of policy, further consideration should be given to allowing monetary—and regulatory—policy to lean against the wind, i.e., tightening policy by more than implied by just the short-term impact on activity and inflation. Fed officials acknowledge the importance of the issue, but thought it too early to draw policy conclusions from the current episode.

B. Fiscal Support

25. While there is room for temporary stimulus and automatic stabilizers, significant medium- and long-term challenges remain (Figure 10). The general government deficit shrank to 2¾ percent of GDP, and the federal fiscal deficit to 1¼ percent of GDP in 2007 as nonsecurity discretionary spending was restricted and capital gains revenues were buoyed by the credit boom. Automatic stabilizers as growth slows will be enhanced as capital gains receipts reverse, although the impact on private spending is likely to be limited as the lower tax liabilities mainly accrue to high-saving households. The usual procyclical cut in spending by state and local governments from balanced budget constraints also may be exacerbated by financial sector problems.

Figure 10.
Figure 10.

United States: Fiscal Indicators

Citation: IMF Staff Country Reports 2008, 255; 10.5089/9781451839715.002.A001

Sources: Haver Analytics; Rockefeller Institute of Government; International Monetary Fund, World Economic Outlook; OECD; Office of Management and Budget; Congressional Budget Office; and Fund staff calculations.

26. Fiscal stimulus is providing well-timed support to activity, more than offsetting short-term strains on income and borrowing. The stimulus package of over 1 percent of GDP mainly comprises tax rebates that will largely go to low- and middle-income individuals. This targeting will help offset the fact that temporary stimulus tends to generate a smaller boost to demand than a permanent change. Experience from the 2001 tax cuts suggests that about half of the transfer will be spent in the spring and summer (part of which will leak away on imports), while the support to business spending from accelerated investment depreciation also in the package is likely to be limited.

27. In staff’s view, were further fiscal action needed, public finances should provide temporary support to housing and financial sectors at the root of problems. The experience of Japan in the 1990s suggests that repeated packages in the face of rea estate and banking problems have diminishing benefits to economic activity, while loosening medium-term fiscal discipline—an important point to bear in mind given the huge U.S. long-run fiscal problem. This implies that if any further fiscal interventions are needed they could more productively focus on limiting short-term risks to house prices and bank lending. Reactions of officials varied, with some noting that targeted spending packages could delay needed adjustment in housing and asset prices and be perceived as “bailing out” reckless behavior. However, others observed that if a much more negative scenario materializes, there could be a role for some limited measures.

United States: Fiscal Projections

(Fiscal years; in percent of GDP)

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Sources: FY 2009 Budget of the U.S. Government (February, 2008); and Fund staff estimates.

Staff projections are based on the Administration’s estimates adjusted for: differences in macroeconomic projections; staff estimates of the costs of the war on terror; staff estimates of the cost of the stimulus package; some additional nonsecurity discretionary expenditure; additional Medicare spending; and continued AMT relief beyond FY2008. PRAs are also assumed not to be introduced.

As a percent of potential GDP, based on proposed measures, under IMF staff’s economic assumptions. Also incorporates CBO adjustments for one-off items.

Calendar year, on a national accounts basis. The projections use Fund staff budget and economic assumptions.

28. While the focus on a balanced federal budget by 2013 is encouraging, significant medium-term pressures are being obscured by unrealistic budget plans. Medium-term balanced budget plans have different emphases: the Administration assumes that non-security discretionary spending will fall in nominal terms, and Congress assumes that most of the 2001/03 tax cuts—equivalent to 1¼ percent of GDP—will expire. More importantly, both Administration and Congressional budget plans include no war funding authority beyond FY2009. Nor do they make any allowance for the costs of annual overrides of legislation that tightens criteria for the alternative minimum tax and reduces compensation to Medicare providers, which the Congressional Budget Office estimates are also worth 1¼ percent of GDP by FY2013. In addition, despite Administration efforts, little progress has been made in Congress on reforming unsustainable pension and health entitlement programs.

29. Thus, staff project the general government deficit in 2013 will remain at around 2¾ percent of GDP, assuming that the 2001/03 tax cuts are extended. As proposed in previous consultations, staff view the more ambitious medium-term target of balance excluding the social security surplus as an appropriate goal to complement needed reform of unaffordable entitlement programs. This suggests a need for further consolidation of over 3 percentage points of GDP by 2013 as well as major entitlement reform. Officials explained that the Administration’s policy is to keep real spending outside security and entitlements constant, which would contribute to a balanced budget, and agreed that progress on reforming entitlement programs is crucial to reducing the main fiscal problem of huge long-term unfunded liabilities.

C. Housing Support

30. Housing support has been helpfully expanded (Table 2). Senior officials agreed that house prices falling below equilibrium is a key risk to the economy. Thus, in addition to supporting efforts to liquefy the market for securitized mortgages through swaps and purchases, the Administration has supported a widening set of schemes to encourage lenders to avoid foreclosures. The HOPE NOW alliance has encouraged voluntary workouts and the Federal Housing Administration (FHA) Secure program has provided FHA loan guarantees to borrowers who are delinquent as a result of ARM resets and some other criteria.

Table 1.

United States: Long-Standing Fund Policy Advice

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Table 2.

United States: Measures to Support the Housing Market—Selected Actions and Proposals

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31. To prevent a damaging overadjustment in house prices, staff favor further expanding the scope of the government’s mortgage guarantee program. Congress is likely to pass a bill supporting voluntary mortgage writedowns by allowing the FHA to guarantee up to $300 billion of loans (2 percent of GDP)—provided that the borrower qualifies and that the new mortgages are at a significant discount to current appraised value. The latter is important, because price declines are estimated to have already left 5–10 percent of homeowners with negative equity (i.e., with houses worth less than mortgage debt), which reduces incentives to service debt. The legislation also includes regulatory reform of government-sponsored enterprises as well as FHA modernization, measures long-sought by both the Administration and the staff. While views vary, and full agreement between Congress and the Administration has yet to be reached, most officials believed that the final package would likely be targeted enough to limit undesirable side-effects (e.g., strategic borrower defaults in order to extract concessions). Correspondingly, a number of observers thought the scheme may be “too little, too late” (too tightly defined to have a significant impact on the foreclosure problem, and taking too long before the FHA gears up to the task).

32. In staff’s view, a scheme with greater creditor incentives could better limit macroeconomic risks without significantly adding moral hazard. Issuing “negative equity warrants” that allow the creditor to share profits from future sales could expand the scope of the current scheme, which runs the risk of limited take-up by lenders. In addition, bankruptcy reform allowing judges to “cram down” reduced mortgage principal on primary residences—as is already allowed for other houses and all other debt—would provide further incentives for creditors to participate. This is particularly important where writedowns are complicated by second lien holders (some 40 percent of subprime and Alt-A mortgages) and by servicers of securitized assets (some 75 percent of mortgages originated in 2007 were securitized). Both actors have limited incentives to pursue loan modifications that crystallize losses upfront. While allowing courts such discretion could raise borrowing costs to homeowners, it could also encourage better risk management by lenders, and recent evidence suggests that the effect on mortgage costs through moral hazard is likely to be small.

33. Officials emphasize that the Administration is responding flexibly to housing woes, but that moral hazard concerns constrain policy options. In their view, the focus of policies should be on helping homeowners who had bought the “right” house (i.e., a fundamentally affordable one) with the “wrong” loan (i.e., with low teaser rates subject to sharp jumps). Accordingly, the Administration supports FHA modernization that would provide more leeway in risk-based pricing of guarantees, and is wary of rigid rules for FHA mortgage support. The Administration also opposes bankruptcy reform on the grounds that abrogation of contracts would curtail future mortgage lending.

D. Bank Support

34. Recent experience underlines the difficulty of letting systemic institutions fail given the complexity of their operations. Staff background work underlines high interdependencies across institutions that appear to rise at times of stress, exacerbating systemic risks (Selected Issues, Chapter 6). Thus, the collapse of Bear Stearns last March led to the Fed’s taking on an exposure of $29 billion (¼ percent of GDP) as part of the firm’s takeover by JPMorgan Chase. The Fed’s leading role was unavoidable, given the speed of Bear Stearns’ loss of liquidity, the span and complexity of its financial linkages, and the risk of a broader asset “fire sale”. That said, staff believe it is more appropriate to use a government agency for any future assumption of assets so as to make transparent the risks to the public purse.

uA01fig16

The Fed Balance Sheet

Citation: IMF Staff Country Reports 2008, 255; 10.5089/9781451839715.002.A001

Source: Board of Governors of the Federal Reserve System.

35. In the face of illiquid markets, the Fed gradually widened access to its liquidity facilities and in time reduced systemic risks (Table 3). Conventional open market operations proved inadequate as counterparties and collateral were too narrowly defined for the unusually strained market circumstances, while stigma limited the use of the discount window. In response, the Fed steadily widened its eligibility criteria for institutions and instruments, increased the maturity of its operations, and lowered its penalty spreads. The process culminated in a facility accepting investment grade asset-backed securities from depositories and—in a striking departure from past practice—from primary dealers, including major investment banks. While calming market concerns about systemic risks, the extension of Fed lending to investment banks implies a reexamination of the rationale for prudential oversight.

Table 3.

United States: Forms of Federal Reserve Lending to Financial Institutions

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36. Notwithstanding moral hazard concerns, were the market instability of last March to recur, staff see a role for longer liquidity facilities. Despite the large capital enhancements and investment banks’ access to Fed loans, such market instability could recur—in which case wider-ranging options for improving the certainty of future market liquidity should be considered. In particular, significantly extending the length of existing swaps of mortgage-backed securities for Treasuries using the government’s balance sheet, as in the United Kingdom, could limit disruption from further market illiquidity. As banks would retain the capital gains and losses on their collateral, the fiscal cost should be limited. Moreover, by giving financial institutions more time to strengthen their balance sheets, such a scheme would facilitate an orderly deleveraging process. Officials observed that the length of swap facilities had been extended as part of the response to financial problems, and that further extension was not contemplated at this time.

37. In staff’s view, any further emergency asset operations should be made by the Treasury rather than via proxies that can obscure potential costs. In addition to the Fed’s taking on an exposure of $29 billion of Bear Stearns’ assets, nearly $300 billion (2 percent of GDP) of secured loans have been made by the Federal Home Loan Banks to mortgage lenders over the past year. More indirectly, the already-light capital requirements for Fannie Mae and Freddie Mac have been loosened further even though they bear the system’s largest exposures to housing-related credit risk. Moreover, recent increases in size limits on conforming mortgages that Fannie or Freddie may purchase reinforce perceptions of an implicit government guarantee of these privately-owned enterprises. Officials view the lifting of Fannie and Freddie’s capital surcharge requirements as response to their improved accounting practices rather than forbearance. However, authorities agreed on the importance of a tighter regulatory regime for these government-sponsored enterprises, as proposed in housing legislation now in Congress.

38. The Fed is well-placed to expand on its existing role as a stability regulator that internalizes systemic risks. This reflects its supervisory powers over bank holding companies and knowledge of market conditions, including counterparty risk concentrations. The Fed is already contributing to improved market infrastructure, e.g., for the netting and settlement of derivative positions. Officials recognize the importance of a systemic supervisor and, pending a thorough overhaul of the system, are strengthening arrangements between the Fed and the Securities and Exchange Commission (SEC) on oversight of major investment banks.

VI. Financial Regulation

39. A key medium-term challenge for policymakers will be to restore confidence in segments of U.S. financial markets, most notably for securitized products. While recognition of the limits of financial engineering has led to a dramatic fall in issuance of structured assets, securitization is likely to recover eventually given its benefits, but with simpler and more transparent instruments. The financial boom also exposed weaknesses from excessively procyclical financial lending, limited consumer protection in the mortgage origination process, and poor incentives within the securitization chain. Private sector actors will address many of these problems, but financial market turmoil has added urgency to the need to improve the fragmented U.S. regulatory system. While specific reforms warrant further consideration, including through the Fund’s Financial Sector Assessment Program starting next year, the staff team initiated a preliminary discussion of the key issues.

A. Bank and Securities Regulation

40. The Treasury blueprint, which sensibly emphasizes regulatory consolidation, is a useful starting point for reform. As discussed in last year’s staff report, regulatory fragmentation and turf battles slow decision-making, blur lines of responsibility, and permit regulatory arbitrage. The Treasury proposes an objectives-based system, with: (1) a prudential supervisor covering depositories and insurance companies; (2) a business conduct regulator for investor and consumer protection; and (3) the Fed as a market stability regulator. However, the blueprint does not address who should regulate investment banks or government-sponsored enterprises. In addition, staff and Fed officials view it as important that, in developing a macro-prudential framework, the Fed retains supervisory powers to ensure it interacts closely with the system it is overseeing.

41. The extension of the financial safety net after Bear Stearns justifies stronger oversight of major investment banks and of liquidity management by all banks. One medium-term option would be to put all systemic financial intermediaries under a single set of regulations and regulator—e.g., by extending umbrella Fed supervision to cover major investment bank and thrift holding companies and also the main government-sponsored housing enterprises. In addition, persistent market pressures suggest liquidity cushions at these institutions, and at commercial bank holding companies, should be managed and supervised more conservatively at the group level, with contingency funding plans that factor-in interruptions of secured financing. Fed officials were sympathetic to the thrust of these views, some of which echo public remarks by the New York Fed president.

42. A tighter focus could also be placed on adequate capital coverage during booms. International efforts through the Financial Stability Forum, the Fund, and the Basel Committee are revisiting capital and liquidity risks, including the use of ratings and treatment of off-balance sheet affiliates. Officials also emphasized the role of the U.S. leverage ratio, which uses the unweighted value of assets—but currently excludes off-balance sheet items—in potentially limiting procyclical lending. Staff discussed other counter-cyclical capital requirements, such as dynamic provisioning already used in Spain, and officials confirmed the general issue was being considered. Some regulators felt fair value accounting rules for hard-to-value assets could be used more flexibly, but most observed that investors remain strongly in favor of fair value accounting’s increased transparency. With market sentiment still delicate, staff agree with the Treasury’s view that the issue should be revisited only after financial conditions have normalized.

43. A Financial Sector Assessment Program, scheduled to start in late 2009, will provide the Fund an opportunity to contribute to the U.S. regulatory debate. Serious consideration of major regulatory reforms will probably have to wait until after the November 2008 election and will likely be a long process. Reforming the regulatory system has been difficult in the past, and the Treasury blueprint already faces resistance.

B. Business Conduct Regulation

44. Staff support creating a business conduct regulator with responsibilities for consumer and investor protection, as discussed in last year’s report. The Treasury blueprint appropriately suggests merging the SEC and the Commodity Futures Trading Commission, whose responsibilities often overlap, and moving responsibility for mortgage consumer protection from the Fed to this new body.

45. In the wake of the housing bust, public attention has focused on the extension of inappropriate loans to unsophisticated borrowers. Provisions under the Home Ownership and Equity Protection Act, the most relevant federal law, did not apply to the vast majority of subprime loans because their rates did not trip unrealistically high interest rate triggers, while enforcement often relied on state regulators. Stricter prudential guidance to banks on nontraditional and subprime mortgage lending was delayed by the need for agreement across five federal agencies. Finally, borrowers who were provided with misleading loan information generally have little redress, particularly when the originator has gone out of business.

46. Legislation can allow higher national standards to be enforced through federal courts. Given the macroeconomic costs coming from imprudent mortgage loans, the Fed is appropriately proposing that subprime mortgage lenders be required to ensure that borrowers can afford the full cost of the loan (not simply low initial rates), to verify a borrower’s income and assets, to ensure local taxes and other costs are placed in escrow accounts, and to limit pre-payment penalties. Also, legislation before Congress rightly triggers federal regulation of mortgage brokers if state supervision is insufficient. Finally, the issue of legal recourse if originators go out of business could be addressed through capped liability for bundlers (see ¶49).

C. Securitization

47. Recent events have highlighted the need to improve incentives in the originate-to-distribute lending model. In a typical mortgage securitization chain, a nonbank originator sells loans to a bundler—generally an investment or commercial bank. The bundler pools the loans into trusts funded by mortgage-backed securities. The trusts pay servicers to collect payments from borrowers and to deal with delinquencies and defaults. Rating agencies are paid to assess the quality of the securities, and “monoline” bond insurers provide insurance against payment shortfalls. Incentives broke down as investors became overly reliant on ratings, while originators and bundlers—who were best placed to assess underlying risks—had few incentives to maintain loan quality.

48. As discussed in the Spring 2008 Global Financial Stability Report, capital charges and ratings transparency of structured credit products could be improved. The Basel committee is revisiting capital charges for off-balance sheet activities, while stronger safeguards against conflicts of interest between advice on structuring products and eventual ratings has been suggested by the International Organization of Securities Commissions. More generally, greater transparency throughout the rating process would allow more effective exercise of due diligence by investors. Newly proposed rules from the SEC are strong first steps, and are expected to be followed by measures to limit references to external credit ratings in bank and securities regulation.

49. Holding bundlers of securitized assets partially legally liable for the assets they create is another possible way of improving securitization incentives. With securitization having increased specialization in finance, the rightful place for quality control in the securitization chain, arguably, is the assembly line. The impact of alternative levels of liability on loans can be examined as some U.S. states and cities have rules assigning capped legal liability to bundlers for “predatory” loans within securitized pools. Academic studies suggest that providing some liability for bundlers improves monitoring of loan quality and standards of loan originators although unlimited assignee liability shuts down the securitization process completely (see IMF working paper WP/07/188). Officials recognize the faulty incentives in the securitization process, but could not commit to specific remedies at this point.

VII. External Adjustment and the Dollar

50. Recent dollar depreciation has moved the dollar significantly closer to medium-term equilibrium (Figure 11). The U.S. current account deficit rose to a record of around 6 percent of GDP in 2005 and 2006 despite gradual depreciation since 2002. This partly reflected strong activity over the housing boom that was supported by heightened foreign demand for U.S. bonds, including mortgage-backed securities. Subsequently, despite a substantially higher oil import bill, this process has gone into reverse, with the current account narrowing rapidly to 5 percent of GDP in the wake of dollar depreciation, slowing domestic demand, and falling foreign net purchases of private U.S. bonds. At current exchange rates, the current account deficit is projected to fall to a more manageable level of just under 4 percent of GDP by 2013, still a bit above the level consistent with medium-term fundamentals.

Figure 11.
Figure 11.

United States: U.S. Competitiveness

Citation: IMF Staff Country Reports 2008, 255; 10.5089/9781451839715.002.A001

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

51. Financial turmoil has reduced capital inflows, contributing to recent dollar depreciation. The dollar lost about 10 percent of its trade-weighted value between mid-2007 and March 2008 before rallying somewhat more recently. Officials view this depreciation as a continuation of the trend initiated in early 2002, reflecting fundamentals such as relative cyclical positions and interest rate differentials. While accepting that these factors play a role, staff see the rapid improvement of the current account as also reflecting capital account developments, notably the sharp reduction in foreign demand for private bonds as a result of financial turmoil: virtually all of the decline in the capital account surplus has fallen on private bonds.

52. Multilateral dollar depreciation has lowered a key global vulnerability—the U.S. external deficit—but the benefit has been diminished by lop-sided bilateral currency movements. In particular, the depreciation of the dollar has generally been larger against freely-floating currencies, such as the euro, rather than against less flexible currencies associated with large external surpluses, such as the renminbi. As a result of these bilateral movements, significant international exchange rate and trade tensions remain.

uA01fig17

Dollar Adjustment and External Imbalances

Citation: IMF Staff Country Reports 2008, 255; 10.5089/9781451839715.002.A001

Sources: Haver Analytics; International Monetary Fund, International Financial Statistics; International Monetary Fund, World Economic Outlook; and Fund staff calculations.

53. This underlines the importance of implementing the strategy agreed during the Multilateral Consultation to combat external imbalances. To maintain growth, the strategy sees the amelioration of global current account imbalances requiring the rebalancing of demand across key countries, not just in the United States. Given short-term economic weakness in the United States, it makes sense to defer progress toward the medium-term objective of a balanced U.S. budget. On the other policy goals set out in the Multilateral Consultation, the U.S. authorities have proposed the following steps, the first three of which still require Congressional action:

  • Reforming the budget process to contain spending growth. This year’s budget again proposes earmark reform and requests the legislative line-item veto.

  • Entitlement reform. The budget again proposes reform of Social Security and a health insurance deduction, plus new initiatives to restructure health insurance markets.

  • Further tax incentives to support private saving. The FY2009 Budget again proposes schemes to expand incentives for saving, including Lifetime Savings Accounts.

  • Enhancing energy efficiency. Congress has passed tighter fuel efficiency standards, with ethanol subsidies also reducing consumption of gasoline.

  • Pro-growth, open investment policies. The Administration has reiterated that it is committed to policies that make the United States attractive to foreign investment.

  • Capital market competitiveness. The Treasury’s Blueprint suggests an improved regulatory structure for the long term and a number of intermediate steps.

54. Staff now consider the dollar closer to the level implied by medium-term fundamentals, although still somewhat on the strong side. Estimates of the equilibrium rate vary significantly. As of early-June, the Fund’s Consultative Group on Exchange Rates’ exchange rate equation suggests slight undervaluation, its comparison with medium-term saving-investment fundamentals suggests a modest overvaluation, and its calculation based on stabilizing the path of net foreign assets as a ratio to GDP implies a 15 percent overvaluation. These differences across the methodologies have been apparent for some time. However, long-term trends in U.S. trade flows and net foreign assets tend to narrow this range, without materially changing the staff’s overall assessment (Box 2). Adjusting for these factors suggest that all three methodologies imply modest dollar overvaluation of 0–10 percent in real effective terms. While not taking a position on the level of the dollar, U.S. officials noted that the dollar had moved in line with fundamentals, including interest rate differentials and relative output.

Special Considerations in the Assessment of the Dollar

The trend switch in U.S. trade toward low-cost producers may mean conventional real effective exchange rate measures overstate the dollar weakness. The basic point is that, even if all prices and exchange rates were constant, the mere fact of growing trade with low cost countries is an implicit loss of competitiveness. Thus, the growing importance of producers with low levels of costs, such as China and Mexico, in U.S. trade may be blunting the benefit from recent dollar depreciation. Conventional exchange rate indices ignore this effect as they either assume fixed trade patterns or ignore differences in cost levels across countries. The implied bias can be estimated using a weighted average relative price (WARP) exchange rate index. This combines updated trade weights with absolute measures of competitiveness derived from purchasing power parities. Results suggest that, using the mid-1990s as a base, the dollar may be 10 percent more appreciated than implied by the Fed’s standard real effective exchange rate index. Furthermore, using WARP indices improves the fit and stability of trade volume equations.

uA01fig18

Real Effective Exchange Rates

Citation: IMF Staff Country Reports 2008, 255; 10.5089/9781451839715.002.A001

1/ Calculation parallels the methodology in Thomas, Marquez, and Fahle (2008).

On the other hand, the U.S. net foreign asset position has fallen much less than cumulative current account deficits—implying lower depreciation to stabilize net debt. The rise in the net foreign debt position from 3 percent of GDP in 1989 to currently 20 percent is well under half of that implied by accumulating current account deficits. While revaluation from dollar weakness has played some role in recent years, it is negligible over the longer term (reflecting the longer-term stability of the dollar). Rather, U.S. investors have consistently made greater capital gains on portfolio and FDI investments, partly reflecting a greater willingness of U.S. investors to take risks. Staff projections assume that, including this difference in risk tolerance, overall valuations changes reduce the implied fall in net foreign assets by some 1 percent of GDP (per year) relative to the amount implied by future current account deficits.

uA01fig19

Current Account and Net Foreign Assets

Citation: IMF Staff Country Reports 2008, 255; 10.5089/9781451839715.002.A001

VIII. Staff Appraisal

55. Despite impressive resilience, the United States faces a difficult situation as the housing bust weakens household demand and worsens credit conditions. The staff’s baseline forecast envisages extremely low growth of GDP in 2008 (Q4/Q4) followed by gradual recovery in 2009. Although inflation expectations have ticked up on surging commodity prices, price pressures should be contained as commodity prices peak and economic slack rises. The outlook crucially hinges on the evolution of house prices, and the dynamic interaction of financial sector and housing cycles. Thus, there are large uncertainties around any projection and policy response to this first national-level housing bust in at least 40 years.

56. Monetary policy should stay on hold for now, while being prepared to raise rates as recovery becomes established. With the real fed funds rate already negative (even using core CPI inflation), monetary policy is already consistent with a robust response to recession risks. Meanwhile, although wage demands remain moderate, elevated headline inflation may have already started seeping into near-term inflation expectations. Given the high cost of reversing such expectations once they become entrenched, the bias going forward should be toward a decisive tightening once recovery is established and financial conditions ease further.

57. Fiscal stimulus is providing support to activity at a critical time, but medium-and long-term fiscal challenges limit the room for further initiatives. The fiscal stimulus package was relatively well targeted toward those who are most likely to spend the money, and its rapid passage in Congress has ensured its benefits are timely. While automatic stabilizers should be allowed to operate, in the face of significant medium-term fiscal challenges, any needed further government support should focus on using balance sheets to support housing and financial markets. A more ambitious medium-term target of balance excluding the social security surplus as well as major entitlement reform remain key to restoring fiscal sustainability.

58. Given the risks, the government should be prepared to widen support for housing and, if serious dislocations reappear, in financial markets. It is true that policies need to be mindful of moral hazard, that the housing sector is already the recipient of large tax subsidies, and that house prices still need to adjust down. Still, there is a clear risk that prices could fall significantly below equilibrium, with painful economic consequences. Given that house prices are falling rapidly and the inventory-sales ratio is at a near-record high, there is a role for public policy to overcome coordination difficulties by using FHA guarantees to encourage lenders to make voluntary write-downs on mortgage principal to new, more affordable loans. Ideally, such legislation would provide additional incentives for lenders to participate. If major systemic financial disruptions recur, the government could support market stability by significantly extending the term of asset swaps, as has been done with Treasury backing in the United Kingdom.

59. Financial regulation could be consolidated and specialized, and liquidity and capital requirements strengthened, including for off-balance sheet lending. The housing boom revealed multiple weaknesses in financial regulation and supervision. While private sector responses will plug some of the gaps, the Treasury blueprint, which includes many proposals highlighted in last year’s report, provides a sensible basis for comprehensive reform. Pending further analysis, including under the Financial Sector Assessment Program, reform options could include reducing the procyclicality of bank lending (e.g., by augmenting risk-based capital ratios) and bringing the oversight of major investment banks and government-sponsored enterprises closer to that of commercial bank holding companies. Finally, with liquidity having emerged as a major and under-emphasized risk, draft recommendations from the Basel Committee will need to be implemented swiftly, taking into account U.S.-specific considerations.

60. Dollar depreciation has moved U.S. competitiveness closer to medium-term fundamentals, but tensions remain in the pattern of bilateral adjustment. The narrowing of the U.S. external deficit has been a welcome global development. However, bilateral rate adjustments have not corresponded to the existing pattern of imbalances, with larger changes against freely-floating currencies (such as the euro) than against currencies of countries with large current account surpluses. Thus, the reduction in the tensions in the international exchange rate and trade system has been more limited than suggested by the trend in the dollar’s real effective rate. This emphasizes the importance of multilateral efforts to reduce global current account imbalances.

61. It is proposed to hold the next Article IV Consultation on a 12-month cycle.

Table 4.

United States: 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 5.

United States: Balance of Payments

(Billion U.S. dollars, unless otherwise indicated)

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Sources: Haver Analytics; and Fund staff calculations.
Table 6.

United States: 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.