United States: Staff Report for the 2016 Article IV Consultation
Author:
International Monetary Fund. Western Hemisphere Dept.
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Publication Date:
12 Jul 2016
eISBN:
9781498358958
Language:
English
Keywords:
ISCR; CR; spending momentum; article IV discussion; staff appraisal; potential GDP; rate; IMF staff estimate; IMF staff calculation; labor market; federal funds rate; Inflation; Global
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This 2016 Article IV Consultation highlights that the United States is now in its seventh consecutive year of expansion. The unemployment rate has fallen to 4.9 percent, and household net worth is close to precrisis peaks. Nonetheless, the economy has gone through a temporary growth dip in the last two quarters. Lower oil prices led to a further contraction in energy sector investment, and a strong dollar and weak global demand have weighed on net exports. With activity indicators for the second quarter of 2016 rebounding, the economy is expected to grow at 2.2 percent and 2.5 percent in 2016 and 2017, which is above potential.

Abstract

This 2016 Article IV Consultation highlights that the United States is now in its seventh consecutive year of expansion. The unemployment rate has fallen to 4.9 percent, and household net worth is close to precrisis peaks. Nonetheless, the economy has gone through a temporary growth dip in the last two quarters. Lower oil prices led to a further contraction in energy sector investment, and a strong dollar and weak global demand have weighed on net exports. With activity indicators for the second quarter of 2016 rebounding, the economy is expected to grow at 2.2 percent and 2.5 percent in 2016 and 2017, which is above potential.

Outlook and Risks

1. The past few quarters have seen a temporary growth setback. The U.S. is entering its seventh consecutive year of expansion. The unemployment rate has fallen to 4.7 percent, household net worth is close to pre-crisis peaks, and inflation remains contained. Nonetheless, the past few quarters have been characterized by a deceleration that is attributable to a continued contraction in energy sector investment; weak non-energy, non-residential investment; and a persistent drag from net exports (linked to weaker global growth and the strength of the U.S. dollar). Although it is more difficult to find proximate causal factors, consumer demand has also slowed. The recent disappointing growth numbers are expected to be short-lived but the latest jobs report does raise concerns that U.S. growth may be losing momentum. However, more data are needed to establish if the previously-positive trajectory for the labor market has shifted. More encouragingly, high frequency indicators point to activity already reaccelerating in the second quarter. Over the near term, we expect growth to be supported by:

  • Labor market. Since the beginning of this year, nonfarm payroll increases have averaged 150 thousand per month and real household disposable income is growing at around 3 percent. The unemployment rate has declined to 4.7 percent, although the cyclical rebound in labor force participation earlier this year appears to have been reversed. Despite the impressive record of job creation, various indicators still point to remaining (albeit diminishing) labor market slack from those that have become detached from the labor force or are involuntarily working part-time.

  • Housing. Most of the stock of foreclosed homes has been reabsorbed and household formation has picked up (although millennials remain constrained by affordability and high debt). Residential investment is expected to continue to rise as a share of GDP and recovering house prices should support household wealth gains.

  • Household balance sheets. So far, lower energy prices have not provided the expected boost to private consumption that was expected (see Box 1). Nevertheless, the oil dividend and strong growth in disposable incomes have allowed households to increase saving and strengthen their balance sheets. Conditioning on the recovery in household net worth, the personal saving rate is now well above levels that would have been predicted by historical patterns.

A01ufig1

Contribution to Growth

(%pts)

Citation: IMF Staff Country Reports 2016, 226; 10.5089/9781498358958.002.A001

Sources: BEA; Haver Analytics; and IMF staff calculations
A01ufig2

Labor Market Slack 1/

Citation: IMF Staff Country Reports 2016, 226; 10.5089/9781498358958.002.A001

Sources: Haver Analytics; and IMF staff calculations1/ Closer to the center signifies less labor market slack
A01ufig3

Household Formation and Vacancy Rates

Citation: IMF Staff Country Reports 2016, 226; 10.5089/9781498358958.002.A001

Sources: Census Bureau; and Haver Analytics; and IMF staff calculations

Weighing these various forces, growth is forecast to be 2.2 percent in 2016 and 2.5 percent in 2017. The output gap, which was estimated at 1 percent of potential GDP in 2015, is expected to close by end-2017 and PCE inflation is expected to slowly rise above 2 percent in 2017–19 before returning to the Federal Reserve’s medium-term target.

A01ufig4

Saving & Net Worth, 1983-2016

(percent)

Citation: IMF Staff Country Reports 2016, 226; 10.5089/9781498358958.002.A001

Sources: BEA; FRB; and Haver Analytics

Economic Forecasts (percent) 1/

article image

CBO projections are from the Budget and Economic Outlook Jan. 2016; FOMC projections are from the June 2016 Summary of Economic Projections; IMF projections are from June 17, 2016.

Year 2021 other than for FOMC

Blue Chip Consensus, June 2016

Consumption and the Oil Dividend

This time is different? Since November 2014, the drop in oil prices has provided a 1 percent of GDP windfall to U.S. households. Prior to the financial crisis, there was an empirically robust “excessive” reaction of consumption to energy price changes (i.e., spending increased by more than the oil price gains1). However, in the most recent episode the consumption response appears small. Post-financial crisis, the elasticity of consumption to energy price changes has fallen from around 3 to 0.4.2 This decline has been observed across all subcomponents of consumption but it has been particularly pronounced for goods consumption (which historically has driven the overall response but now appears insensitive to energy price changes).

Why? Multiple factors are clearly at play, including the shift of the U.S. to being more energy self-sufficient in recent years. It is premature to have a conclusive view on the drivers but some stylized facts may be indicative:

  • There no longer appears to be the same positive impact of lower oil prices on consumer confidence—a leading indicator of durable goods purchases—as in the pre-crisis era. Indeed, the near-term effects on confidence now appear, if anything, to be negative.

  • The correlation between equity prices and oil prices has shifted from -0.3 percent pre-crisis to +0.6 percent in 2010–15. As a result, the associated wealth and confidence effects on consumption from rising equity valuations is now working in the opposite direction.

  • The impact of oil prices on the interest rates on consumer credit are more muted than they have been in earlier historical episodes (i.e. in the 1970–80s). Indeed, it has been hard to detect any reduction in credit costs from lower oil prices since the early-1990s.

A01ufig5

Decomposition of PCE Elasticity to Lower Energy Prices

(percentage points)

Citation: IMF Staff Country Reports 2016, 226; 10.5089/9781498358958.002.A001

Source: IMF staff estimates
A01ufig6

Response of Consumer Confidence to 10% Lower Gas Prices

(index points)

Citation: IMF Staff Country Reports 2016, 226; 10.5089/9781498358958.002.A001

Source: IMF staff estimates
A01ufig7

Response of Rates on Auto Lending to 10% Lower Gas Prices

(percent)

Citation: IMF Staff Country Reports 2016, 226; 10.5089/9781498358958.002.A001

Source: IMF staff estimates
1 See, for example, Eldstein and Kilian (2009) and Hamilton (1996). 2 Estimates are based on a VAR framework using monthly data on real consumption from the PCE and unanticipated changes in real income from changes in gasoline prices. Consumption elasticity is defined as the percent change in consumption associated with a 1 percent increase in energy spending.

2. Lower oil prices and increasing energy independence have combined to contain the U.S. current account deficit over the past year. This has been despite the cyclical growth divergence with respect to trading partners and the rapid rise in the U.S. dollar. However, over the medium term, at current levels of the real exchange rate, the current account deficit is expected to rise above 4 percent of GDP. Net financial inflows were about 2 percent of GDP in 2015 with rising portfolio inflows being offset by weakness in direct investment and other inflows. The net international investment position (NIIP) fell to -39 percent of GDP in 2015 and, under staff’s baseline outlook, the NIIP would deteriorate by a further 10 percent of GDP over the next five years (largely due to the projected current account deficits).

3. Risks to the growth outlook are balanced:

  • The path of the U.S. dollar. The 13 percent real appreciation of the U.S. dollar since the summer of 2014 has taken its toll on manufacturing investment and net exports. Looking forward, the future path of the dollar represents a symmetric risk to the U.S. outlook:

    • On the downside, further appreciation, particularly if driven by a divergence in the inflation outlook between the U.S. and other systemic economies (rather than by diverging growth prospects) would eat into growth (Box 2). The current level of the U.S. dollar is assessed to be overvalued by 10–20 percent and the current account deficit is around 1.5–2 percent of GDP larger than the level implied by medium-term fundamentals and desirable policies (see Annex IV). As such, a strengthening in the dollar would serve to push the external position further away from levels justified by medium term fundamentals.

    • Conversely, a continuation of the depreciation that occurred since the beginning of the year would represent an important upside to both growth and inflation.

  • Energy sector investment and output. The decline in crude prices has caused oil companies to curtail investment by about 40 percent in 2015 (subtracting 0.4 percent from GDP growth). In 2016, energy investment is expected to fall by another 30 percent, subtracting 0.2 percent from growth. The risks to growth associated with the future path of oil prices are asymmetric.

    • On the downside, the compression of capital spending that has already occurred implies that even at lower oil prices, larger-than-expected falls in investment will be small as a share of GDP and have only a minor impact on growth.

    • However, if oil prices sustain their current levels and tight financing conditions for the sector begin to normalize, oil-related investment could resume, with a modest upside risk to activity (Box 3).

  • Non-oil investment. A shrinking output gap and decent prospects for future domestic demand growth should support investment in non-oil, non-residential sectors. However, recent data has shown such investment moving in the opposite direction. This could be reflective of the strength of the U.S. dollar or perhaps broader industrial spillovers from the downturn in the energy sector. It could also reflect a more structural trend at work as U.S. output becomes less intensive in physical capital and more reliant on human and informational capital. If true, this would pose a downside risk to aggregate demand as the economy adjusts to the new equilibrium.

  • Finally, a consumption effect? To date, there has been little apparent consumption stimulus from lower oil prices (the personal savings ratio stands at 5.4 percent, up ½ percent since mid-2014). Nonetheless, lower oil prices are helping to strengthen household balance sheets, particularly for lower income households. This should, at a minimum, increase the resilience of the economy to negative shocks and could mean a belated reaction of consumption. As such, this offers an unambiguous upside to the growth forecast.

  • U.K. exit from European Union. Staff estimates suggest the impact on U.S. growth of a disruptive U.K. exit from the European Union are likely to be modest. The principal channels would come through a sustained rise in global risk aversion that would lead to a compression of U.S. sovereign yields, a rise in the U.S. dollar and a sell-off in risk assets. However, given the unprecedented nature of the event, the broader effects-including on the U.S. economy and its large financial system-are highly uncertain and could evolve in unpredictable and more negative ways than indicated by macro models.

  • A misjudgment about potential growth. There is a risk that staff’s outlook has over-estimated both the historical path of potential growth and the degree of slack that currently exists. If true, this could mean that the economy is now starting to bump up against capacity constraints (including in the labor market). As such, growth for the coming years could settle at well below 2 percent. Perhaps more problematic, a lower path of potential could give rise to an unexpected acceleration in inflationary pressures in the near-term, leading the Federal Reserve to more assertively raise the policy rate. This would cause the dollar to appreciate and increase asset price volatility (as market participants find themselves wrong-footed).

    • Spillover implications. Such a scenario would have important negative spillovers, particularly given that the global economy currently appears ill-prepared for a rapid rise in U.S. policy rates, for capital to flow back to the U.S., for risk premia to rise, and for the dollar to accelerate upwards. Such near-term negative spillovers would be further exacerbated by the real transmission effects of a path for medium-term U.S. growth that is well below current expectations.

A01ufig8

REER and Net Exports

Citation: IMF Staff Country Reports 2016, 226; 10.5089/9781498358958.002.A001

Sources: BEA; FRB; and Haver Analytics
A01ufig9

Oil Investment and WTI

Citation: IMF Staff Country Reports 2016, 226; 10.5089/9781498358958.002.A001

Sources: BEA; Haver Analytics; and IMF staff calculations
A01ufig10

Growth: Potential and Actual

(percent)

Citation: IMF Staff Country Reports 2016, 226; 10.5089/9781498358958.002.A001

Sources: BEA; and IMF staff estimates

4. Risks are skewed toward lower inflation. Further dollar strength would present a drag to imported inflation. However, even in the event of a stable currency, the significant global excess capacity seen across a range of tradable goods may lead to a protracted decline in tradable goods prices. This would be further exacerbated if the recent pattern of downgrades to global growth prospects continues. Finally, changing dynamics in the U.S. labor market, that are at this point not fully understood, may mean that the expected pick up in nominal wages could prove elusive, further weighing on inflation.

5. Authorities’ views. Tepid growth over the last few quarters was viewed as likely to be transitory, especially when contrasted with the strong labor market data through April. Given the maturation of the cycle, the pace of job gains is expected to slow but, in May, job growth slowed substantially more than expected and that abruptness seems inconsistent with other more positive activity indicators. In the coming quarters, it was expected that sequential growth rates would pick up and moderately exceed potential growth. Near-term risks to the growth outlook were considered to be broadly balanced but there was some modest downside potential to inflation outcomes, particularly given weak global trends and the impact of residual seasonality on data in the first half of the year. Concern was expressed about the continued widening of the U.S. current account deficit, particularly as a symptom of weak global demand. Counterparts emphasized the importance that countries, including the U.S., use all available policy tools to boost demand. Officials also highlighted a number of advanced and emerging market economies with large external surpluses (including China, Germany, Japan, Korea, and Taiwan Province of China) which could usefully bolster domestic demand and, in so doing, contribute to stronger global growth and a more balanced world economy.

Drivers of the U.S. Dollar

Drivers. Uncovered interest parity seems to be rejected by the data (see Engle 2013 for a review) but a more expansive theory would argue that exchange rate movements could be related to:

  • Expected cumulative short-term rate differentials (as measured by movements in long-term rate differentials that capture divergences in medium-term neutral rates as well as inflation and monetary policy prospects);

  • Foreign exchange risk premia (extracted from survey expectations of exchange rates from Consensus Forecasts); and

  • Movements in the equilibrium real exchange rate (e.g. due to changes in the terms of trade).

A01ufig11

$/Euro Dynamics and Interest Differential

Citation: IMF Staff Country Reports 2016, 226; 10.5089/9781498358958.002.A001

Sources: Consensus Forecasts; FRB; Haver Analytics; and IMF staff calculations
A01ufig12

$/Euro Dynamics and Risk Premium

Citation: IMF Staff Country Reports 2016, 226; 10.5089/9781498358958.002.A001

Sources: Consensus Forecasts; FRB; Haver Analytics; and IMF staff calculations

Empirical findings. A VAR framework1 that adds variables to proxy global and country-specific shocks (VIX, WTI, expected inflation differentials, expected growth differentials, and short-term interest rates), reveals:

  • FX risk premia and the 10-year interest rate differentials have a significant and persistent effect on exchange rates.

  • A global uncertainty shock (proxied by a higher VIX) induces an appreciation of safe haven currencies and the U.S. dollar rises against all other major bilaterals except the Yen.

  • Commodity currencies, such as the Canadian dollar, are sensitive to oil price movements including through a knock-on effect on the foreign currency risk premium.

A01ufig13

Trade-Weighted Dollar Response to Risk Premium and Interest Differential Shocks

(percent) 1/

Citation: IMF Staff Country Reports 2016, 226; 10.5089/9781498358958.002.A001

Source: IMF staff estimates1/ Trade-weighted by Euro, Canadian dollar, UK pound, and yen; 68% bands
A01ufig14

Dollar IRFs to VIX Shock

(percent)

Citation: IMF Staff Country Reports 2016, 226; 10.5089/9781498358958.002.A001

Source: IMF staff estimates
1 See Balakrishnan, Laseen, and Pescatori, “U.S. Dollar Dynamics: How Important are Policy Divergence and FX Risk Premiums?” IMF Working Paper (2016).

U.S. Shale Oil and Global Spillovers

The shale oil “revolution”. The U.S. oil industry experienced one of its most dramatic shifts in 2010–15 when the combination of high prices and technological change (notably horizontal drilling) allowed a doubling of U.S. crude production. Both the number and productivity of rigs increased with important implications for the oil market and global economy more broadly.

Scenarios. Forecasts of future production face tremendous uncertainty but scenarios can help identify the range of possible future outcomes. Specifically, we examine three scenarios:

  • Baseline. Draws on the prediction of the future rig count that would be consistent with the current medium-term WTI forecast in the WEO; assumes a linear improvement in productivity;

  • Upside. Assumes a similar rig count to the baseline but with a quadratic upward trend for productivity per rig;

  • Downside. Assumes decreasing gains in productivity (i.e. uses a concave trend) and lowers the estimated impact of WTI price on the rig count by one standard deviation.

A01ufig15

Total Production and Production per Rig

Citation: IMF Staff Country Reports 2016, 226; 10.5089/9781498358958.002.A001

Source: IMF staff estimates

The differential impact on production from these modest changes in assumptions is large. By 2020, U.S. production could range from 3.5 to 8.4 million barrels per day depending on the scenario (the baseline scenario is very similar to the EIA’s latest forecast).

Global Spillovers. Using the G20 model, these shale oil scenarios are found to have:

  • Relatively symmetric effects in the upside and downside scenarios, with the decline in global oil prices in the upside scenario leading to an increase of global GDP of about 0.4 percent.

  • The biggest winners in an upside production scenario are India and Korea which have large oil imports. The most negative effects are for Saudi Arabia and Russia, as they are highly dependent on oil and have limited trade links with the US.

  • Despite the significant oil price decline in the upside scenario, Canada and Mexico (which are oil exporters) receive a marginally positive short-term impact on GDP because of their strong trade links with the U.S. However, these effects turn moderately negative by 2021.

A01ufig16

Upside Scenario Real GDP, 2021

(% diff.)

Citation: IMF Staff Country Reports 2016, 226; 10.5089/9781498358958.002.A001

Source: G20

6. Near-term fiscal policy has been well-calibrated to the prevailing economic circumstances. At the general government level, the change in the structural primary balance is expected to be −½ and 0.1 percent of GDP in 2016 and 2017, respectively. This should be mildly supportive of growth, particularly if gauged against the fiscal contractions (of around ½ percent of GDP) experienced in 2014–15. From a macroeconomic perspective, both near-term fiscal and monetary policies appear consistent with the need to provide modest support to the economy as it transitions toward full employment in the face of global and domestic headwinds (near-term fiscal and monetary policy settings are in line with recommendations in the 2015 Article IV, see Annex I).

7. Fiscal uncertainties have been diminished by the passage of:

  • The Bipartisan Budget Act of 2015 which suspended the debt ceiling until March 2017 and avoided the risk of government shutdown by locking in appropriations for 2016 and 2017.

  • Protecting Americans from Tax Hikes Act that lowered tax revenues by 3½ percent of GDP over the next 10 years. Among the many provisions, the bill made permanent the enhanced child tax credit, the American Opportunity tax credit for college tuition, and the improvements to the earned income tax credit (i.e. the expansion to larger families and removal of the marriage penalty). The bill also made permanent the research and experimentation credit for corporations (which had been temporarily extended 15 times since 1985, sometimes retroactively).

  • Fixing America’s Surface Transportation Act that commits US$305 billion to surface transportation for the next 4 years and provides some degree of stability to states in planning projects that are co-financed with federal resources.

8. The Affordable Care Act (ACA) was the most comprehensive health reform since the introduction of Medicare and Medicaid in 1965. Data is now beginning to emerge as to its effects. Health insurance coverage has risen significantly, with the uninsured falling to 9.1 percent of the population in 2015. However, this still means 28.8 million people remain without insurance. The remaining uninsured are mainly low-income young adults and non-permanent immigrants, including those with incomes that are too high to qualify for Medicaid (in those 19 states that chose not to expand Medicaid to households that earn less than 133 percent of the federal poverty threshold) but too low to receive ACA insurance premium subsidies. Following passage of the ACA, health costs have been rising at a slower pace (PCE health care inflation has risen, on average, by 1.4 percent per year over the past 5 years). The impact of the ACA on labor supply remains unclear and subject to large uncertainties. The Congressional Budget Office estimates the ACA would reduce hours worked by around 1.7 percent by 2025 (although other empirical studies have smaller effects). Also, the ACA requirement to maintain children on a parent’s insurance until they are 26 years old appears to have raised the wages of young adults. Finally, the early evidence suggests that the ACA has provided some support to those below, or close to, the poverty line (simulation analysis points to a 6 percent increase in the income equivalent for the lowest quintile).

A01ufig17

Uninsured Rate

(percent of population)

Citation: IMF Staff Country Reports 2016, 226; 10.5089/9781498358958.002.A001

Source: National Health Interview Survey

9. The volatility in financial markets in the early part of 2016 does not detract from the fact that financial conditions have been very supportive of the real economy (Figure 1). This is particularly true after parsing out the effects—on equity and bond prices—of the evident stress in energy and mining companies. Most notably, the availability and cost of financing for households—mortgage rates, auto loans, and the senior loan officer survey—remain very favorable. Also, as risk-free rates have trended downwards, investment grade yields of non-energy companies have generally been moving sideways.

Figure 1.
Figure 1.

Financial Conditions

Citation: IMF Staff Country Reports 2016, 226; 10.5089/9781498358958.002.A001

Sources: Haver Analytics and IMF staff calculations

10. Risks to the U.S. financial system are broadly unchanged from that of a year ago.

  • The U.S. banking system continues to strengthen its capital position. Tier 1 capital is at 13 percent of risk weighted assets (RWA), with increasing RWA density (now at 71 percent). The system appears resilient to a range of extreme market and economic shocks. The results of the 2016 Comprehensive Capital Analysis and Review exercise will, however, be released in June, precluding an updated assessment relative to the 2015 Article IV. Measures to bolster bank liquidity, as well as strengthen recovery and resolution, are being steadily implemented.

  • There are some pockets of vulnerability. These include credit quality in auto lending, student loans, and commercial real estate lending. Energy and mining loan exposures are also likely to bear losses. However, these are relatively small parts of the U.S. financial system. Compressed interest margins continue to weigh on bank profitability and are causing intermediation to increasingly move to the nonbank sector, including mortgage origination and servicing being relocated to specialist non-banks. However, such mortgages are predominantly being securitized by the government sponsored enterprises and meet the debt-to-income and underwriting requirements of the Qualified Mortgage standard. Housing market policies, including expanded lending by the Federal Housing Administration, are, however, leading to looser underwriting standards which could, over time, worsen the credit quality of mortgages.

  • The various financial stability issues highlighted in the 2015 FSAP, for the most part, have not been addressed (Annex II). These include data blind spots, the lack of risk management requirements and stress testing for the asset management industry, residual vulnerabilities in repo markets and money market funds, the complex institutional structure for financial regulation, a housing finance system that remains in limbo, and an incomplete understanding by the regulators of financial interlinkages.

  • A large U.S. insurance company appealed its designation by the Financial Stability Oversight Council as a Systemically Important Financial Institution. Subsequently, a federal court has ruled on the case and decided to rescind the designation. The Financial Stability Oversight Council is currently appealing that court decision.

  • The potential lack of market liquidity in a range of fixed income instruments, particularly at times when markets are under stress, remains a concern that could increase the risk of destabilizing forced asset sales or create volatility in market pricing. In the new regulatory environment, banks’ balance sheet space for market-making activities has become tighter and alternative market systems are still unable to provide a full offset. Such market illiquidity not only induces more price volatility but also has the potential for creating macro-financial effects. However, adaptation is already occurring on multiple fronts as buy-side institutions arrange their activities with an understanding that liquidity-under-stress will be lower.

A01ufig18

FHA Mortgage Originations

Citation: IMF Staff Country Reports 2016, 226; 10.5089/9781498358958.002.A001

Sources: Ellie Mae; Haver Analytics; and IMF staff calculations

The Supply Side Challenges Ahead

11. Despite the sustained economic expansion, the U.S. faces a confluence of forces that will weigh on the prospects for continued gains in economic well being. A rising share of the U.S. labor force is shifting into retirement, basic infrastructure is aging, productivity gains are scanty, and labor markets and businesses appear less adept at reallocating human and physical capital. These growing headwinds are overlaid by pernicious secular trends in income: labor’s share of income is around 5 percentage points lower today than it was 15 years ago, the middle class has shrunk to its smallest size in the last 30 years, the income and wealth distribution are increasingly polarized, and poverty has risen.

12. These secular trends both interact and reinforce each other. Demographic changes are slowing potential growth, delaying the renewal of business equipment, and depressing labor force dynamism. Reduced dynamism in the corporate sector has the potential to diminish innovation, deepen the loss of middle income jobs, and further polarize the income distribution. Income polarization itself can prevent productivity-improving investments in education by poorer households, lessen social mobility, add to economic insecurity, and limit consumption prospects. The causes of and interactions between these various forces are complex and not well understood. Skill-biased technological change, the more globalized and integrated market for goods and labor, changing structures of industrial and labor markets, and insufficient offsetting domestic policy actions are all feeding into these dynamics. However, what is clear is that these trends are coinciding with a well-documented decline in potential growth (from above 3 percent in the early 2000s to below 2 percent today) that is being mirrored across a range of advanced and emerging economies. If left unchecked, these forces will continue to drag down both potential and actual growth, diminishing gains in living standards and worsening poverty.

13. Demographics are an immutable headwind. The aging of the baby boom generation is set to cause a fall in the growth of the working age population in the coming years as well as a steady decline in labor force participation. As a consequence, the labor force is projected to grow at just 0.5 percent per year over the next decade (significantly slower than the 0.9 percent growth of the past 25 years). Falling growth in the labor force and a higher dependency ratio will eat into potential growth and add to medium-term fiscal challenges. Indeed, aging-related spending is forecast to cause an inflexion point in the public debt GDP ratio starting in 2019, raising concerns over the sustainability of the current medium-term fiscal trajectory (see below).

A01ufig19

Demographic Shift

Citation: IMF Staff Country Reports 2016, 226; 10.5089/9781498358958.002.A001

Sources: Census Bureau; Haver Analytics; and IMF staff calculations
A01ufig20

Consensus Long-run Growth Forecasts

(%)

Citation: IMF Staff Country Reports 2016, 226; 10.5089/9781498358958.002.A001

Source: Consensus Forecasts
A01ufig21

US Average TFP Growth

(percent)

Citation: IMF Staff Country Reports 2016, 226; 10.5089/9781498358958.002.A001

Sources: BLS; FRB; Haver Analytics; and IMF staff calculations1/ For multi-factor, 2011-2015. 2010 is included in 2000s

14. Since the late 90s and early 00s, total factor productivity (TFP) in the U.S. has slowed significantly. TFP growth has been close to zero in the past 5 years and estimates of labor productivity have seen a similar decline. This slower productivity growth has been a global phenomenon and there is evidence it is related, at least in part, to a slower pace of innovation, a generalized decline in economic dynamism and the pace of new firm formation, rising firm concentration, falling labor market turnover, and the continued shift from manufacturing to services.

15. There has been a marked decline in labor market dynamism. In contrast to the “job-less recovery” of the early 2000s, the current expansion has seen relatively healthy employment growth but wage gains have been anemic. Over one-half of the post-recession employment gains have been accounted for by the 55-and-over population who find themselves with insufficient income for retirement (and, as a result, are working later in life). In addition, churning—a measure of labor market dynamism that has been correlated with real wage growth—has followed a downward trend for both men and women, is at historically low levels, and seems connected to slower productivity growth (Box 4).

16. Firm creation and destruction are also below historic levels. Business dynamism (i.e., business birth, growth, and exit) plays a critical role in the reallocation of resources from less-productive activities to more-productive ones. An important component of the observed fall in business dynamism has been a marked decline in firm startups and a decreasing role of young businesses in the economy. Since newer businesses have much higher innovation intensity than their more mature counterparts, their declining presence is eating into productivity. Contributing factors for this measured drag to dynamism include shifting patterns in the IT sector (which contributed substantially to business formation until the mid-2000s but has now matured as an industry) and increasing firm concentration (which is adding to the market power of incumbents and potentially acting as an implicit barrier to entry).

A01ufig22

Dynamism

(percent)

Citation: IMF Staff Country Reports 2016, 226; 10.5089/9781498358958.002.A001

Sources: Longitudinal Business Database; and IMF staff calculations

17. The labor share of income has seen secular decline which began to accelerate in 2000. This is a phenomenon that has also been seen in other advanced economies. The evidence suggests a combination of factors are at work including wage competition from abroad, a compositional shift in GDP toward services (where the labor share is lower), and a decline in the labor share within manufacturing and industry (particularly for import-exposed sectors). Explanations for the latter range from a generalized decline in unionization rates, a shift of manufacturing activity to southern and western states that prohibit union security agreements, and an off-shoring of more labor-intensive tasks within manufacturing and industry.

A01ufig23

Income Distribution and Labor Share

Citation: IMF Staff Country Reports 2016, 226; 10.5089/9781498358958.002.A001

Sources: BLS; Current Population Survey; and IMF staff calculations

The Decline of U.S. Dynamism

Labor market fluidity. Since the late 1980s, American workers have been changing jobs less frequently1. Quit and layoff rates have declined and job-to-job moves—a common practice for workers as they move up the wage ladder—have fallen by 40 percent. As a result workers are holding fewer jobs during their careers, reallocating less across sectors, and accumulating less transferable skills. The decline in job-to-job moves may also be a partial explanation behind lower wage growth and a falling labor share of income.

Firm formation. The structure of the corporate sector is mirroring these labor market changes. The rate of business entry and exit has been on a secular decline. This was initially concentrated in a few sectors (e.g. retail) but, over the past 15 years, this declining pattern has broadened to include more innovative sectors such as technology.

A01ufig24

Job-to-Job Transition Rate

(percent)

Citation: IMF Staff Country Reports 2016, 226; 10.5089/9781498358958.002.A001

Sources: Census Bureau; and IMF staff calculations

The link to productivity. It has been no coincidence that, during this same period, the most productive firms have been growing at a slower pace. Within individual industries business concentration has risen and the dispersion of productivity across firms within a sector has grown.2 The decline in labor market fluidity could well have slowed the allocation of employee talent to productive firms and, in so doing, suppressed overall productivity growth.

Why? Reasons for falling dynamism are difficult to untangle given the two-way causality between productivity and business or labor churning. Demographics and a changing industry mix explain only a small part of the decline. More favorable interpretations (such as more efficient job-matching) do not appear to be supported by the data. Recent research3 has focused on slow-moving structural causes although, empirically, the relative merits of these explanations are unclear:

  • Greater hurdles for firms to enter and workers to reallocate due to rising legal and regulatory constraints (e.g. limits on at-will employment, noncompete agreements in labor contracts, or increasing barriers in business and occupational licensing);

  • Changes in corporate business models that better exploit economies of scale, including greater vertical integration within a company, bounded by the constraints imposed by anti-trust rules;

  • Evolving social preferences, including a diminishing willingness to take employment risks.

A01ufig25

Firm Entry Rates Across Sectors

(percent)

Citation: IMF Staff Country Reports 2016, 226; 10.5089/9781498358958.002.A001

Sources: Census Bureau; and IMF staff calculations
1 S. Davis and J. Haltiwanger (2014) “Labor Market Fluidity and Economic Performance,” NBER Working Papers 20479 and S. Danninger, “Is the US Labor Market Changing” IMF Working Paper (2016). 2 R. A. Decker, J. Haltiwanger, R. S. Jarmin and J. Miranda (2015). “Where Has All The Skewness Gone? The Decline In High-Growth (Young) Firms In The U.S,” NBER Working Papers 21776. 3 R. Molloy, C. L. Smith, R. Trezzi and A. Wozniak (2016) “Understanding declining fluidity in the U.S. labor market”, Brookings Papers on Economic Activity.

Polarization and Consumption1

Divergent paths. Since the 1970s, the real income of families in the low to middle income brackets have stagnated while real income growth of higher brackets has accelerated since the late 1990s.

Polarization. Over the last four decades, many households have moved out of middle-income groups (defined as those earning 50–150 percent of the median income) and into the tails of the distribution. Since 2000, this “hollowing out” of the middle class, has been tilted more toward movements into the lower than the higher income ranks.

Wealth. The net worth of households has also polarized. The real net worth of those groups who earn less than two-thirds of the median income is now 20 percent below where it was when the data started in 1983. Meanwhile the average real net worth of those earning more than twice the median income has doubled since 1983.

Consequences. Staff estimates suggest that rising polarization has led to a lower aggregate consumption over the past 15 years, as more households have moved to the low-income tail of the distribution with more limited resources for consumption. In addition, empirical work shows that the overall marginal propensity to consume of these lower income groups has not increased. Staff estimates that these effects have lowered the level of aggregate consumption by about 3½ percent (equivalent to more than one year of consumption) since 1998.

A01ufig26

Real Median Family Income by Income Percentiles

(2005$ thousands)

Citation: IMF Staff Country Reports 2016, 226; 10.5089/9781498358958.002.A001

Source: Current Population SurveyNote: Adjusted for family size using OECD’s equivalence scale.
A01ufig27

Household Real Net Worth

(percent of 1983 real net worth)

Citation: IMF Staff Country Reports 2016, 226; 10.5089/9781498358958.002.A001

Sources: Census Bureau; and IMF staff calculations
1 See A. Alichi, K. Kantenga, and J. Sole, “Income Polarization in the United States”, IMF Working Paper (2016) and “The American Middle Class is Losing Ground”, Pew Research Center (2016).

18. The re-profiling of the economic structure, coupled with skill-biased technological progress in both services and manufacturing, has contributed to a shrinking of the share of the population in middle income jobs and a broader polarization of the income distribution (Box 5). Since the mid-1980s, the number of semi-skilled jobs paying incomes around the national median has fallen and jobs are instead being created either at the upper or lower ends of the occupational skill distribution. This phenomenon has been dubbed “job polarization”. At the same time, the earnings of workers remaining in the middle and lower segments of the skill distribution have stagnated or fallen. A direct consequence has been the “hollowing out” of the income distribution. The share of households earning between 50 and 150 percent of the median income has fallen from 58 to 46 percent over the past 45 years. An even more pronounced but connected trend has taken place in the polarization of the wealth distribution. This has had broad, macro-relevant, consequences for consumer behavior, human capital accumulation, and the housing market.

A01ufig28

Share of Households by Income

(percent)

Citation: IMF Staff Country Reports 2016, 226; 10.5089/9781498358958.002.A001

Source: Current Population SurveyNote: Adjusted for family size using OECD’s equivalence scale

19. In parallel with the polarization of the income and skills distribution, there has been a steady increase in poverty in the U.S. In the latest data, 1 in 7 Americans are living in poverty, including 1 in 5 children and 1 in 3 female-headed households. Further, around 40 percent of those in poverty are working. The incidence of poverty has been unusually persistent even as the economic expansion has matured. Poverty levels today are higher across age cohorts and for both men and for women. All of the progress that was made in lowering poverty during the 1990s has now been unwound. There are overlapping factors at work that include a greater premium for skills, a declining progressivity of the tax system, compositional changes in sectoral employment and educational attainment, as well as the broader economic dislocation triggered by the financial crisis.

A01ufig29

Poverty Rates

(percent of total population)

Citation: IMF Staff Country Reports 2016, 226; 10.5089/9781498358958.002.A001

Sources: Census Bureau; Haver Analytics; and IMF staff calculations1/ Takes account of government programs designed to assist low income families

Policy Strategies

20. Reducing poverty requires national efforts that are complemented by targeted responses in states and localities where the incidence of poverty is most concentrated. In the near-term, a more generous earned income tax credit (including eligibility for workers without dependents, those under 25, and older workers that are not yet eligible for social security) combined with a higher federal minimum wage would help alleviate poverty. These two measures would have strong complementarities. The improvements in the EITC can work in tandem with the minimum wage to ensure a meaningful increase in after-tax earnings for the nation’s poorest households (see 2014 Article IV). Upgrading social programs to support the nonworking poor would also be a step forward. This could include simplifying and unifying the various programs underlying the safety net, increasing the generosity of those programs, learning from the diversity of experiences at the state-level to identify the most effective approaches, and targeting federal payments toward achieving specified outcomes. Efforts to improve K-12 education, invest in early childhood education, subsidize healthcare and childcare for lower income families, and expand needs-based support for tertiary and vocational education can have important effects, over a longer horizon, in reducing the inter-generational persistence of poverty.

A01ufig30

Effective Minimum Wage by State, 2015

Citation: IMF Staff Country Reports 2016, 226; 10.5089/9781498358958.002.A001

Sources: BEA; Census Bureau; Department of Labor; and Haver Analytics
A01ufig31

Poverty and Social Spending

Citation: IMF Staff Country Reports 2016, 226; 10.5089/9781498358958.002.A001

Source: OECD latest available data; and IMF staff calculations1/ OECD categories: Incapacity, Unemployment, and Other social policy areas

21. Authorities’ views. The administration has repeatedly argued for raising the minimum wage and expanding the EITC for workers without dependent children as well as workers that are 21-24 and 65-66 years old. The President’s budget also makes the case for providing high-quality preschool to lower income families, instituting full day kindergarten in every school district, and expanding funding for programs that support learning and development of the neediest children. More recently, the overtime regulations had been updated, doubling the salary threshold to US$ 913 per week and extending coverage to 4.2 million lower income workers. Moreover, the threshold will now be automatically updated every 3 years based on wage growth. Officials also saw merit in reexamining the structure of safety net spending, particularly given that the generosity of cash poverty alleviation programs had declined in recent years with additional spending funded without an increase in the deficit.

22. Falling labor force participation is an inevitable consequence of an aging society but those demographic effects can be mitigated. Improvements in the EITC, discussed above, will help encourage work. It will also be important to:

  • Adopt family-friendly benefits, particularly as a policy lever to slow the downward trend in female labor force participation. These would include providing means-tested support for childcare and introducing paid family leave in line with standards in ILO conventions.

  • Rework the disability insurance program to provide incentives for beneficiaries to work part-time (rather than drop out of the labor force).

  • Finally, perhaps the largest effect on the labor supply would come from an agreement on an immigration reform that is skill-based, changes the underlying demographic trends, reduces the dependency ratio, and raises the average level of human capital in the labor force.

A01ufig32

Labor Force Participation Rate

(percent)

Citation: IMF Staff Country Reports 2016, 226; 10.5089/9781498358958.002.A001

Sources: BLS; and IMF staff estimates

23. Authorities’ views. Adverse demographic trends made supporting working families a high priority so as to use the U.S. labor force most effectively. The 2017 Budget proposes federal funding for start-up grants to assist states in introducing paid leave programs and providing federal employees with six weeks of paid administrative leave for the birth, adoption, or foster placement of a child (currently new parents who are federal employees are allowed to draw down six weeks of their sick leave and take twelve weeks of unpaid leave). The budget also supports increasing childcare subsidies for lower income families with young children and raising the child and dependent care tax credit (to a maximum amount of US$3,000 per child for families with children under age five). The administration is committed to common sense and comprehensive reform to fix the broken immigration system and has taken executive actions to offer relief from deportation for the parents of citizens or legal residents who have lived in the U.S. for more than five years.

24. Raising productivity and bridging the skill divide will be essential. Since the boom of the late 1990s, total factor productivity has slowed significantly. This appears to be a global trend that is not confined to the U.S. Notwithstanding this, public policy tools could help facilitate innovation and technological progress, and support efficiencies in private activity:

  • Expanding infrastructure investment. The public capital stock is aging and has been declining as a share of GDP for some time. New investment is urgently required to improve the quality and reliability of infrastructure, particularly for surface transportation. This will help remove bottlenecks and congestion and add to the productivity of private activity. Public projects to upgrade infrastructure technologies (e.g. in high speed rail, ports, or telecommunications) would be particularly valuable. In parallel, innovative solutions should be sought to facilitate the financing (both public and private) of U.S. infrastructure. It is estimated that such investments could cost about 5–8 percent of GDP over the next 10 years which should be financed without an increase in the near-term fiscal deficit (i.e., by reallocating spending from other areas and raising revenues). Estimates suggest that such an expansion in infrastructure investment could boost potential growth by around ¼ percent.

  • K-12 education. There is a clear need for better spending on education so as to raise educational outcomes. This could include prioritizing funding for early childhood education (including financing of universal pre-K) and supporting science, technology, engineering, and mathematics programs.

  • Vocational education. Closing the skills gaps would be facilitated by greater federal support for state-level training as well as the expansion of partnerships between industry and higher education institutions to facilitate apprenticeships and vocational training.

  • Trade integration. The free exchange of goods and services has been a hallmark of American economic success. New trade agreements, such as the Trans Pacific Partnership (TPP), cement and extend this principle by going beyond the removal of tariff barriers—which are already low—and include rules on investment, competition policy, intellectual property rights, and regulations. By preserving a level playing field in future growth areas, such as services, the TPP has the potential to set a new standard and pathway for international economic cooperation. It would also aid the U.S. economy by capitalizing on its strength in the fast growing area of tradable services. Resisting all forms of protectionism will also be essential. There will likely be transition costs to both jobs and incomes from greater trade integration as well as potential effects on income polarization. The consequences for trade-affected U.S. workers should be taken into account and policy efforts should be taken to mitigate the downsides through training, temporary income support, and job search assistance, including deployment of the existing trade adjustment assistance program.

A01ufig33

Quality of Infrastructure

(score 1-7 best)

Citation: IMF Staff Country Reports 2016, 226; 10.5089/9781498358958.002.A001

Source: Global Competiveness Index, World Economic Forum
A01ufig34

Public Investment, Structures

(% of GDP)

Citation: IMF Staff Country Reports 2016, 226; 10.5089/9781498358958.002.A001

Sources: BEA; Haver Analytics; and IMF staff calculations
A01ufig35

Average PISA Score, 2012

Citation: IMF Staff Country Reports 2016, 226; 10.5089/9781498358958.002.A001

Sources: OECD; and IMF staff calculationsNote: PISA (Programme for International Student Assessment) 2012 tested students in mathematics. Sample range is 65 emerging and OECD countries
A01ufig36

Tertiary Education

Citation: IMF Staff Country Reports 2016, 226; 10.5089/9781498358958.002.A001

Source: OECD latest available data
A01ufig37

Private Services Exports

(US$ billions, 2013)

Citation: IMF Staff Country Reports 2016, 226; 10.5089/9781498358958.002.A001

Sources: U.S. International Trade Commission; WTO; and IMF staff calculations

25. Authorities’ views. The administration has proposed a “surge” in new infrastructure and clean energy investment funded through an excise on crude oil and a one-time 14 percent tax on unrepatriated corporate profits (as a transition to broader business tax reform). There has been broad recognition of the importance of education and job training to support future growth and productivity. The administration has already expanded grants and tax credits to increase access to college and had proposed making community college free for two years. There is a hope that the recent step to make the research and experimentation tax credit permanent could help with productivity. Federal funding for job training has been increased in recent years, and, in the past two years, 75,000 additional individuals have been enrolled into federally-supported apprenticeship programs. Continued efforts along these lines could help lessen the skills mismatch that is currently visible in the U.S. labor market. There is a strong commitment to working with Congress to pass the TPP and move ahead with other plurilateral trade agreements. The U.S. is committed to resisting financial and trade protectionism. Given that trend declines in productivity are widespread globally, officials noted the value of further examining the productivity slowdown from an international perspective.

26. Steps should also be taken to avoid self-inflicted wounds from future disagreements on the path for fiscal policy. Whatever gains could be achieved in supporting growth through the supply-side measures described above could be easily dissipated by a repetition of past political brinkmanship over appropriations and the debt ceiling. Near-term uncertainties have certainly been diminished by the passage of the Bipartisan Budget Act of 2015, the Protecting Americans from Tax Hikes Act, and the Fixing America’s Surface Transportation Act. However, it will be important to identify more lasting institutional solutions.

  • One possibility would be to replace the debt ceiling with a bipartisan agreement on a clear, simple medium-term fiscal objective (with an integrated view of all budget functions and numerical goals for both debt and deficit).

  • Alternatively, a legislative process could be introduced that adjusts the debt ceiling automatically, consistent with whatever agreement is struck on the broader budget parameters.

  • Carefully-designed mechanisms could be built in to support fiscal discipline by triggering automatic revenue or spending adjustments if congressionally approved targets are breached.

  • Consideration could also be given to more permanently shifting to a budget cycle where annual spending levels are agreed for a two-year period (helping to divorce budget decisions from the electoral calendar).

27. Demographic trends and rising interest rates will lead to larger fiscal imbalances over the medium-term. Specifically, over the next decade healthcare and social security outlays are expected to increase by 1¾ percent of GDP and interest spending will rise by 2 percent of GDP. As a consequence, the federal debt is forecast to begin rising in 2019 and exceed 80 percent of GDP by 2025. Regrettably, the U.S. continues to lack a detailed medium-term fiscal consolidation plan to prevent this renewed rise in the public debt. Such a plan would need to target a medium-term federal government primary surplus of about 1 percent of GDP (a general government primary surplus of about ¾ percent of GDP) which would put the public debt ratio firmly on a downward path. Since many of the policies needed to boost growth and tackle poverty will have fiscal implications—the largest of which is linked to public infrastructure spending—their costs should fit within this overall deficit envelope.

A01ufig38

Federal Debt Held by the Public

(percent of GDP, fiscal year)

Citation: IMF Staff Country Reports 2016, 226; 10.5089/9781498358958.002.A001

Source: IMF staff estimates

28. Achieving this medium-term path will require actions on multiple fronts:

  • Tax reform. The Joint Committee on Taxation estimates that a comprehensive reform of the U.S. tax system that removes exemptions, simplifies the system, and reduces statutory rates (both for individual and corporate income taxes)—would raise the level of real GDP by up to 1.6 percent over the next ten years. Reform of the corporate income tax is badly needed and could help revitalize business dynamism and investment (Box 6). For the personal income tax, the structure could be made more progressive so as to help mitigate income polarization and assist the working poor. This could involve capping itemized deductions, including for mortgage interest, to lessen the tax benefit for the most well off. Finally, as has been advocated in past consultations, additional revenues should be generated through the introduction of a federal level VAT and a broad-based carbon tax (see 2015 Article IV), including an increase in the federal gas tax (which has been 18 cents per gallon since 1993).

  • Pension reform. The expected depletion of the social security trust fund calls for early steps toward fundamental reform of the pension system. These would include raising the income ceiling for social security contributions, indexing benefits and contribution provisions to chained CPI, raising the retirement age, and instituting a greater progressivity in the benefit structure.

  • Healthcare cost containment. Healthcare inflation has come down but it appears largely linked to slow wage growth in the health sector (which has already started to bounce back). More is needed to sustainably lower the path of future healthcare costs. This could be achieved through better coordination of services to patients with chronic conditions, greater cost sharing with beneficiaries, innovations in efficiency technologies (e.g. electronic health care records, remote consultations with doctors, international outsourcing of some diagnostic functions), and changing incentives away from remuneration per procedure and toward payments for achieving specified health outcomes. Higher Medicare premiums would also help address financial imbalances in the publicly-funded health system.

29. Authorities’ views. On the tax side, the administration has argued for closing personal income tax loopholes for “carried interest” and to limit the value of itemized deductions and other tax expenditures for higher income households. They also would favor increasing the top tax rate on capital gains and dividends to 28 percent. The President has proposed a comprehensive, revenue-neutral business tax reform that would reduce the corporate tax rate to 28 percent, eliminate dozens of inefficient tax expenditures, impose a 19 percent minimum tax on foreign earnings that would be paid currently without possibility of deferral (with no additional tax upon repatriation), and limits on the use of excessive interest deductions by foreign companies to strip earnings. The administration recognizes there are imbalances in the entitlement system and has, over time, put forward various measures that could be part of a “grand bargain”—to strengthen the solvency of the system. In this regard, it was important not to understate the important progress, in part linked to the Affordable Care Act, that has been made in lowering the pace of cost increase in health care (which will lessen the medium-term fiscal imbalances due to aging). Tackling the financing gap in the social security system while ensuring beneficiaries receive robust benefits was seen as an increasing priority.

Estimated Fiscal Impact of Various Policy Options

(cumulative primary deficit change, 2017–20251)

article image
Sources: CBO; JCT; ASCE; and IMF staff estimates

Expressed as a percent of average 2017–2025 GDP.

Reform of the U.S. Corporate Income Tax1

The shortcomings. There is bipartisan acceptance that the U.S. system for taxing corporate income is broken. The current tax structure is too complex, has a marginal rate that is too high and with a narrow base, is rife with legislated exemptions, favors debt financing, and incentivizes a range of cross-border avoidance and tax planning mechanisms to lower U.S. tax liabilities. Despite the well-documented distortions and shortcomings, and their negative implications for both productivity and the global competitiveness of U.S. businesses, reforming the system has proven politically impossible.

The priorities for incremental reform:

  • Reduce the corporate income tax rate to 25 percent.

  • Broaden the CIT base by eliminating the bulk of corporate tax expenditures including the Section 199 deduction (for domestic production activities) and repeal the corporate alternative minimum tax.

  • Align depreciation allowances with rates of economic depreciation. Eliminate tax incentives for petroleum exploitation, including publicly traded partnerships.

  • Adopt the recommendations of Base Erosion and Profit Shifting Action 4 by limiting interest deductions to 10–20 percent of EBITDA for both domestic and foreign-owned firms to reduce income-stripping as well as debt bias.

  • Adopt a territorial system by excluding dividends of foreign subsidiaries from U.S. taxation. On a going-forward basis, impose a 15 percent country-by-country minimum rent tax on the foreign earnings of U.S. corporations. Maintain the current system of crediting for foreign taxes paid.

  • Tax the existing stock of un-repatriated foreign-sourced earnings at a rate of 25 percent, with payments spread over the next 8 years.

A01ufig39

Statutory Corporate Tax Rates

(percent)

Citation: IMF Staff Country Reports 2016, 226; 10.5089/9781498358958.002.A001

Source: OECD

More fundamental reform. Over a longer horizon, the U.S. should transform its corporate tax system into a rent tax. This would involve allowing U.S. corporations a general capital allowance against earnings for both debt and equity-financed investment and then taxing the remaining rents at a lower marginal rate. Normal returns to capital should be taxed at the investor level including by removing the current tax exempt status for pension funds and endowments. Partial crediting should remain for foreign taxes paid.

1 See K. Clausing, E. Kleinbard and T. Matheson, “U.S. Corporate Income Tax Reform and Its Spillovers”, IMF Working Paper (2016)

A Slow Train to “Normal”

30. Since the first rate increase in December, the predicted pace of subsequent rate increases has slowed (in both the FOMC and market’s expectations). Despite a string of strong labor market data, there has been concern around weak activity and, more recently, jobs data, recurrent bouts of financial market volatility, and diminishing global prospects. The FOMC has emphasized the shallow, gradual upward slope in its expected policy rate profile and has underlined that the federal funds rate is likely to remain, for some time, below levels that were expected to prevail in the longer run.

A01ufig40

Policy Rates Expectations

(percent)

Citation: IMF Staff Country Reports 2016, 226; 10.5089/9781498358958.002.A001

Sources: Federal Reserve; Bloomberg; and IMF staff estimates

31. Wage and price inflation appears contained. Price developments have been marginally above staff’s expectations at the time of the last Article IV. However, wage indicators appear moderately softer than had been previously envisaged, despite the labor market repairing on a faster-than-expected timetable. Over the past 12 months, compensation growth as measured by the employment cost index has fallen to under 2 percent and average hourly earnings are only modestly higher (at 2.5 percent). Despite this, inflation outcomes are currently expected to follow a slow trajectory back to the central bank’s medium term target as labor market slack is steadily exhausted.

A01ufig41

Core PCE Inflation

(percent, yoy)

Citation: IMF Staff Country Reports 2016, 226; 10.5089/9781498358958.002.A001

Sources: BEA; and IMF staff estimates
A01ufig42

Wage Growth

(percent, yoy)

Citation: IMF Staff Country Reports 2016, 226; 10.5089/9781498358958.002.A001

Sources: BLS; FRB; and Haver Analytics
Figure 2.
Figure 2.

Inflation Dynamics

Citation: IMF Staff Country Reports 2016, 226; 10.5089/9781498358958.002.A001

Sources: BEA; and IMF staff calculations

32. Evidently, monetary policy should remain data dependent. It is also important to note that it will be the whole expected future path of rate movements that will be relevant for the macroeconomy. At this point in the cycle, there is a clear case to proceed along a very gradual upward path for the fed funds rate, conscious of global disinflationary trends and confirming along the way that wage and price inflation are indeed maintaining their steady upward momentum. Evidence suggests that the trade-off between slack and price pressures appears to have remained reasonably stable (Box 7). Staff’s own macroeconomic outlook is built on an assumption of two further rate increases in the second half of 2016 and the forecasted outturns for growth, inflation, and unemployment are broadly in line with the FOMC’s own summary of economic projections. Given the likelihood and severity of downside risks to inflation, the potential for a drift down in inflation expectations, the Federal Reserve’s dual mandate of maximum employment and price stability, and the asymmetries posed by the effective lower bound, the path for policy rates should accept some modest, temporary overshooting of the Federal Reserve’s inflation goal to allow inflation to approach the Fed’s 2 percent medium-term target from above. Doing so will provide valuable insurance against the risks of disinflation, policy reversal, and ending back at a zero fed funds rate (see Working Paper). The Federal Reserve should be clear in communicating its intentions and emphasize that its medium-term inflation goal is symmetric and that inflation could well approach their target from above. If either wage or price inflation becomes visible at a faster pace than is embedded in staff’s current forecasts, interest rates should be raised on a more front-loaded timetable.

33. Authorities’ views. A healthy labor market—notwisthstanding the slowdown in job growth in May—and real income growth were expected to support a pickup in consumer spending, leading to a faster pace of GDP growth in the coming quarters. The low unemployment rate appears, at present, to be exerting little upward pressure on wage or price inflation. However, with consumer demand growth continuing, the dollar no longer appreciating and energy prices apparently having bottomed out, there was confidence that inflation would move steadily upward to the 2 percent objective in the medium run. If incoming data shows economic growth continuing to pick up, labor market conditions continuing to strengthen, and inflation making progress toward 2 percent, then it likely would be appropriate to gradually increase the federal funds rate in the coming months. However, incoming data would determine the timing and pace of future rate adjustments. There is no preset course for the policy rate. Officials indicated that the Federal Reserve’s medium term inflation goal should not be viewed as a ceiling and there were likely to be symmetric errors around the 2 percent target. However, there was no intention to engineer an overshoot the inflation objective and the welfare case for doing so was not compelling. There was a concern also that aiming to overshoot the medium-term target would create the risk of being behind the curve and potentially being faced with a need to raise rates more quickly especially if the labor market tightening led to a faster increase in inflation than seen until now. This could be disruptive and undermine the achievement of the Federal Reserve’s mandates of maximum employment and stable prices.

Did the Global Financial Crisis Break the U.S. Phillips Curve?1

A structural break? Since the global crisis, the combination of high unemployment and a lack of wage deflation, followed by a period where unemployment was declining steadily without an acceleration in wage growth, has raised questions as to whether the nature of the unemployment-inflation trade-off has changed. Particularly, has the Phillips curve flattened or shifted to become less responsive to “slack”?

A multivariate approach. Using a large-cross-section Bayesian Vector Auto Regression and dynamic factor model that exploits a wide range of data in a flexible framework, we find that there is some evidence, post-recession, that the nature of underlying shocks to the economy has changed. However, there is little evidence of a change in the coefficients of the Phillips curve. In addition, corporate bond spreads are found to be an important predictor of unemployment2 and financial and external variables are predictive of inflation.

Markov-switching. A separate approach was deployed using a flexible, New Keynesian model that allows for 3-state regime switching both in the structure of shocks and in the model coefficients. The model that best fits the data is one that shows no change in the Phillips curve itself but a change in the coefficients in the monetary policy reaction function. This change in the reaction function induces a shift in the time series variance-covariance structure between inflation and unemployment. The Phillips curve has, according to these results, not broken. Rather, describing recent dynamics needs a structural model that allows for a shift in the monetary policy reaction function in order to best explain the post-financial crisis changes in the structure of correlations seen in the data. Estimating a single equation Phillips curve, without allowing for such changes in the policy reaction function, would make it erroneously appear as if the Phillips curve itself has tilted downwards.

A01ufig43

Phillips Curve Shift, 1992-2015

(percent)

Citation: IMF Staff Country Reports 2016, 226; 10.5089/9781498358958.002.A001

Sources: BEA; CBO; Department of Commerce; FRB; and IMF staff calculations1/ Unemployment gap uses CBO’s NAIRU; PCE gap uses SPF 10yr expectations
1 See Laseen, S. and Taheri Sanjani, M., “Did the Global Financial Crisis Break the U.S. Phillips Curve?”, IMF Working Paper (2016) 2 See Gilchrist and Zakrajsek (2010) “Credit Spreads and Business Cycle Fluctuations”, NBER Working Paper 17021.

Keeping the Financial System Safe

34. Regulatory reforms, improved risk management practices, and changing business practices have strengthened the U.S. banking system. Compared to European and Asian peers, U.S. banks have stronger portfolios and are considerably more profitable. However, net interest margins remain compressed and corporate credit risk is rising (although the latter deterioration has been largely concentrated in energy and mining where the banking system as a whole has only a modest exposure). A small number of non-systemic banks with a high portfolio concentration in distressed sectors (notably energy and mining) are likely to see increases in loan losses. Furthermore, a potential worsening of credit quality for auto and commercial real estate loans could create a broader increase in provisioning needs. All in all, though, these downsides represent pockets of vulnerability but are unlikely to prove systemic. Banks will continue to face a lower profit environment going forward but regulatory levers and market discipline appear to be in place to prevent efforts to restore profitability translating into weaker lending standards.

A01ufig44

Bank Health and Prosperity

(percent) 1/

Citation: IMF Staff Country Reports 2016, 226; 10.5089/9781498358958.002.A001

Sources: Bloomberg; EBA; and IMF staff calculations1/ Data is as of 2015 or latest available

35. Intermediation activity is further migrating from banks to nonbanks and is likely to continue to do so as policy rates increase. This argues for caution, including in assessing the effects of higher policy rates on overall risk (Box 8). For instance, mortgage origination and servicing have, to a large extent, moved off of bank balance sheets into specialized entities that sell the loans for eventual securitization by government sponsored agencies. As the structure of the housing finance industry evolves, the associated risks bear close examination. Retail deposits have, so far, remained in the banks but, as rates rise, money market funds offering higher returns could increasingly pull funding from the banks (which are constrained by regulatory liquidity measures and the costs of deposit insurance).

Securitization and Monetary Policy: Watch Out for Unintended Consequences

The approach. An empirical exercise was undertaken using a proxy-VAR drawing on flow of funds data to trace through the effects of higher policy rates on credit flows in different parts of the financial system1.

The role of securitization. Estimates suggest that a monetary policy tightening does act as a liquidity shock for banks that (temporarily) raises their costs of funds and puts pressure on bank profits, cash flow, and liquidity. As a result, banks cut back on credit creation. However, since securitization provides a source of funding and liquidity, it also appears that a higher federal funds rate causes U.S. banks to liquefy part of their assets (mostly mortgages) and expand lending through securitization. Specifically, a monetary policy tightening causes the total supply of mortgages and the securitization of conforming (i.e., GSE) mortgage loans to fall. However, higher policy rates result in an increase in private-label asset backed mortgage securities. In addition, the GSEs themselves expand lending to the Federal Home Loan Bank system.

A01ufig45

Impact of Higher Policy Rate on Mortgage Credit

Citation: IMF Staff Country Reports 2016, 226; 10.5089/9781498358958.002.A001

Implication. The evidence suggests that higher policy rates do “get in the cracks” with broad effects on the financial system but that they do so in very uneven ways. Specifically, our analysis suggests that different forms of financial intermediation do not react in a uniform way to policy rate shocks. As policy is tightened, financial activity migrates from bank balance sheets to the less-well monitored non-bank sector (including via securitization). In the current context, this channel for disintermediation poses a lower risk than in the past, given the subdued private-label securitization activity. However, in the aftermath of the global financial crisis, new channels of credit creation have opened up in the nonbank sector (including ETFs and asset management vehicles) so that the overall impact of monetary policy decisions on financial risks and activities is far from clear.

1 See Pescatori, A., and J. Sole “Credit, Securitization and Monetary Policy: Watch Out for Unintended Consequences”, IMF Working Paper 16/76 (2016).

36. Many of the policy recommendations for the nonbanks made during the 2015 IMF Financial Sector Assessment Program remain pertinent today, but have not been implemented (Annex II). Two areas are particularly worth reiterating:

  • Asset managers. On-demand vehicles (such as mutual funds) that are ultimately invested in less-liquid fixed income assets have the potential to create market instability due to liquidity mismatches and redemption or first-mover risks. As one indicator, the share of less liquid corporate and foreign bonds held by mutual funds has doubled since 2009, to 21 percent. Regulation is currently being explored to tackle these risks. However, to adequately analyze the evolution of interconnections, exposures, and potential buildup of risks among asset managers, there is a strong case to accelerate the work on building a more complete and transparent data landscape of the asset management industry. This should go hand in hand with a structured effort to implement comprehensive stress testing programs for the asset management industry that focus on liquidity and counterparty risks.

  • The life insurance industry. The life insurance sector intermediates 30 percent of GDP in assets that are leveraged. The low-interest rate environment and market pressures to maintain returns at a sufficient level have forced firms to change asset composition (toward nontraditional asset classes, private equity, and lower-rated fixed income) and compete on the liability side (through an increase in unit-linked and guaranteed-return products). However, there is a lack of clarity, at an overall portfolio level, of the underlying risk profile of the life insurance industry and how it has evolved (Box 8), and the absence of harmonized national standards or consolidated supervision makes any assessment of risks in the industry necessarily tentative and incomplete. A coordinated, nationally consistent approach to regulation (particularly valuation and solvency requirements), supervision, and stress testing is needed with regulatory oversight assigned to an independent agency with a nation-wide mandate, operational independence, and appropriate powers and accountability. For designated institutions, enhanced prudential standards should be implemented without further delay.

37. Authorities’ views. Leverage in the system on average does not appear high and risks appear manageable. However, supervisors were closely watching risks associated with the concentration of leverage and deteriorating credit quality in certain parts of the system. Over the past few years there has been a clear recognition of the financial stability concerns that may arise from liquidity and redemption risks in pooled investment vehicles (particularly mutual funds that invest in less liquid assets). Work is now underway to improve liquidity management practices, reporting and disclosure for mutual funds and to impose limits on a fund’s ability to hold assets with very limited liquidity. While the structure of financial markets is evolving, markets have weathered well the dislocations in the beginning of the year, indicating that market participants have been adapting to the new environment. Efforts were ongoing to better understand the structure of different markets and how they interact. Steps were being taken to build a better database on cash treasury markets, enhance data collection and reporting on securities lending and repos, and form an interagency working group to examine the potential risks to financial stability from hedge fund activity. There was shared concern that regulators do not have a complete picture of the risks being taken in the nonbank system. The Securities and Exchange Commission is developing proposed rules to enhance the regulatory framework over the U.S. asset management industry, which includes enhanced reporting and risk management requirements, limits to leverage, and—for registered investment companies sand advisers—transition planning to address a potential major disruption in their business. Separately, the alignment of repo and triparty settlement has eliminated intraday credit risk, thereby completing the triparty repo reform. There was increased concern on the operational risks to the financial system from a serious failure in either a market’s or an individual entity’s cyber security protections, an interagency collaboration was underway to better understand and address these risks.

38. Important gains have been made in strengthening the financial oversight structure. Over the past several years a series of decisive measures were put in place to lessen the potential for financial stability risks, including enhanced capital and liquidity requirements, better underwriting standards in the housing sector, greater transparency to mitigate counterparty risks, and limits on proprietary trading. The Dodd Frank Act requirements have stimulated supervisory intensity, with increased emphasis on banks’ capital planning, stress testing, and corporate governance. The Federal Reserve’s Comprehensive Capital Analysis and Review process has proven to be particularly valuable. Further important regulatory measures have been, or are being, implemented including liquidity risk requirements for money market and mutual funds; standardization of derivatives products and markets; measures that reduce banks’ medium term asset-liability mismatch (through the net stable funding ratio), and a framework for bank recovery and resolution (i.e., rules on living wills and bail-inable debt).

39. These improvements in financial oversight need to be preserved. Eight years after the inception of the financial crisis, political support behind the reform of the financial system has clearly ebbed and there is a danger that the indispensable progress that has been made may stall or be rolled back. Of course, it is natural to recalibrate some aspects of the oversight system as changes are seen in action. Nevertheless, it will be important to oppose any wholesale or broad-based efforts to dilute the provisions of the Dodd-Frank Act.

40. Authorities’ views. There is a strong commitment to continue to strengthen efforts to monitor potential risks and emerging threats to financial stability. Changes to the structure and practice of financial system oversight since the financial crisis have served to make the system stronger, safer, and more resilient. Future changes to the regulatory structure will continue to be driven by data and evidence-based analysis and will involve broad collaboration among the various regulators under the umbrella of the Financial Stability Oversight Council. However, as the memory of the financial crisis fades, there was a risk that some may want to let the guard down on financial reform. Nevertheless, the administration was committed to ensuring that efforts to roll back the Dodd-Frank Act would be resisted.

Developments in the U.S. Life Insurance Sector

A01ufig46

Portfolio Composition

(percent of assets)

Citation: IMF Staff Country Reports 2016, 226; 10.5089/9781498358958.002.A001

Sources: Federal Reserve Board; and IMF staff calculations
A01ufig47

Investments

(percent of assets/liabilities)

Citation: IMF Staff Country Reports 2016, 226; 10.5089/9781498358958.002.A001

Source: IMF GFSR April 20161/ Incl. direct lending, investment banking, and mutual & hedge fund investment

Assets. U.S. life insurers’ investment portfolios have changed considerably over time with a declining presence of mortgages and rising investments in direct lending, equity, mutual funds, and hedge fund investments. At the same time, average duration has risen and life insurers are now more sensitive to abrupt increases in interest rates (although a slow rise in rates would benefit the industry). However, given the inability of having a clear portfolio view of the asset side of the sector, and the correlations among asset classes, it is difficult to assess the extent to which credit, liquidity, and market risk of the sector has changed over time.

Liabilities. U.S. life insurers have increased the share of insurance products that have higher guarantees or early withdrawal features. As a result, exposure has risen to lapse-induced liquidity risk (with lapse rates between 4 and 7 percent across large firms). In the event that liquidity shortages give rise to asset liquidation in volatile markets, the market liquidity risk that is being borne by the life insurance industry on the liability side has likely risen.

Oversight and supervision. Insurance supervision has been strengthened by bringing it under the oversight of the FSOC and creating the Federal Insurance Office. However, the regulatory system remains fragmented at the state level (despite the ongoing internationalization and globalization of the industry) and Federal Reserve oversight of the systemic insurance groups is still being developed.

41. The withdrawal of correspondent banking relationships has created spillover risks for some countries, particularly those that are unable to substitute to other financial connections in a timely manner. As in other jurisdictions, a number of globally active U.S. banks have been reducing their correspondent banking relationships with counterparts in a range of countries. There is a confluence of factors potentially driving this phenomenon—including shortcomings in the AML/CFT framework in recipient countries, higher supervisory scrutiny, the changing global economic environment, profitability concerns, low margins in correspondent banking, changing liquidity and capital requirements, a broader reorientation of bank business models, insufficient regulatory clarity, reputation concerns of the banks, possible conflicts in regulations (e.g. with data privacy laws), and economies of scale in compliance. On the U.S. side, the legal framework for sanctions, AML/CFT, and tax information sharing appears to be applied in a manner that is proportional to the seriousness of the violation. Nevertheless, regulators should continue their investments in outreach and in the ongoing clarification of regulatory expectations. While the risk-based regulatory approach should strive to provide more clarity, there should be no expectation that U.S. regulators and enforcement agencies are able to offer either certainty or “safe harbor”. The U.S. should continue its efforts to assist recipient countries to build capacity and work with other jurisdictions to foster global and bilateral solutions to data privacy impediments. Adherence to the international standards on AML/CFT and the sharing of tax information would help to alleviate concerns about the adequacy of controls at recipient institutions. It is worth exploring mechanisms for U.S. financial intermediaries to lessen the fixed costs of compliance and risk management by pooling resources and exploiting economies of scale (e.g. utilizing specialist transfer and clearing services, building common platforms, and sharing information on clients). There may also be scope for U.S. banks to vary more the risk-pricing of correspondent services so as to factor compliance costs into their fee structure and make the risk-return profile more efficient (see Box 10 and Staff Discussion Note).

42. Authorities’ views. Due to the prevalence of U.S. banks in global finance, their withdrawal from certain correspondence banking relationships has affected certain jurisdictions. The U.S. remains fully committed to continuing outreach and supporting capacity building in recipient countries. Recent studies on the impact of withdrawal from corresponding banking relationships on remittances flows and U.S. dollar clearing have given mixed results so the causes and effects are still unclear. Regulators noted the increased use of consent orders by U.S. supervisors and the Department of Justice and the broad intentions to resolve violations with remedial measures taken by financial institutions. Regulators’ principle focus was to ensure that internal controls were appropriate and proportional to the risks of the institutions’ operations. Indeed, the supervisors’ preference was for these activities to remain within the regulated financial system but with institutions having appropriate risk-based controls in place.

43. A more structured, uniform and complete solution is needed to the current lack of transparency in beneficial ownership in the U.S. A lack of information on the beneficial ownership and control of U.S. corporations and trusts has given rise to loopholes for criminal financial activities, including domestic and foreign based tax evasion. The U.S. authorities recently issued regulations to strengthen the requirements for U.S. financial institutions to identify and verify beneficial owners of the companies whose accounts they maintain. They also proposed regulations requiring foreign owned, single member companies to provide ownership information to the tax authorities. However, given that corporate registration and trusts are governed by the states under a variety of statutes, a complete solution will require federal legislation to make beneficial ownership information readily available to regulatory and law enforcement bodies.

44. Authorities’ views. Treasury officials underlined the importance they attach to ensuring a more transparent and uniform approach to making available beneficial ownership information. They indicated that that the leaks from the Mossack Fonseca law firm had highlighted the globally widespread use of corporate entities and trusts to avoid and evade taxes and to conceal corrupt practices. Officials indicated that the issue of global tax avoidance and evasion was a huge problem that necessitated both international cooperation and a multilateral solution. Transactions structured solely around tax avoidance undermined public confidence in the tax system and violated the basic principle of making sure that everyone pays their fair share. New Treasury regulations will help and the administration was committed to working with congress to legislate steps to provide regulators with the information they needed to undertake their statutory obligations.

Withdrawal of Correspondent Bank Relationships

Trends and implications. Many globally active banks, including those based in the U.S., have been scaling back correspondent banking relationships (CBRs). While the number of such relationships has been declining, there are indications that the volume of correspondent activity continues to rise. Nevertheless, prospective shifts in CBRs could impair cross-border financial intermediation (including remittance transfers or trade finance), limit the provision of financial services to certain jurisdictions, and cause customers and/or activities to migrate to areas with lower regulatory and supervisory visibility and control.

Multiple drivers. The forces leading to this rearrangement of CBRs have included:

  • A broader realignment of bank business models as a result of changes to capital and liquidity rules, the requirement for foreign banks to establish bank holding companies in the U.S., a structural decline in profitability of various business lines, and significant fixed costs for the banks associated with maintaining a compliant, risk-based approach to correspondent activities;

  • Increasing economic, financial and reputational risks facing banks from undertaking certain forms of cross-border activities, particularly those that bear the risk of both supervisory and criminal enforcement actions for the violation of rules on money laundering, financing of terrorism, tax evasion, sanctions programs, or intermediating the proceeds of narcotics trafficking;

  • Tighter post-crisis regulation and broader reporting requirements (including those related to AML/CFT) that require investments in transaction monitoring systems, processes to flag, examine and report suspicious transactions, customer due diligence, and the maintenance of transaction records; and

  • Conflict of regulations such as those that arise from data privacy constraints on cross-border information sharing on the transactions in respondent banks and prevent U.S. based banks from undertaking the needed due diligence with their foreign bank clients.

Regulatory clarity. On balance, the U.S. regulations while complex appear clear and generally well understood by most global banks, particularly those with a sizeable U.S. footprint. However, some global banks headquartered in Europe argued that regulations were inconsistently communicated and unevenly implemented, asking for more regulatory clarity. To their credit, the U.S. authorities have undertaken extensive outreach and education efforts, particularly to foreign jurisdictions and internationally active banks. This has included placing in the public domain supervisory manuals, case law, implementing regulations, and outreach presentations.

A risk-based approach. The U.S. regulators and enforcement agencies have been clear that they are looking for adequate systems (in terms of compliance function and internal audits) to manage the risks the financial institutions face. The regulators are not advising the discontinuance of activities but would prefer the risks are, instead, managed and the activity is maintained within the regulated financial system. There appears a proportional process of escalation from supervisory involvement, to enforcement action, and eventually prosecution or sanctions, with most cases being resolved with remedial measures. The oft-cited cases with large fines have involved egregious, widespread, repeated and systemic violations of either sanctions rules or the Bank Secrecy Act. Most banks appear to be assessing CBRs against their risk-return profile, and on a case-by-case rather than wholesale basis.

Policy options:

  • U.S. regulators should continue their investments in outreach, the clarification of regulatory expectations, and building understanding of the underlying standards relating to AML/CFT, sanctions, tax issues, and narcotics-linked transactions.

  • The U.S. should continue its efforts to assist recipient countries to build capacity.

  • The U.S. should continue to work with other jurisdictions to foster global and bilateral solutions to data privacy impediments such as helping to structure carve-outs to local privacy laws that allow for information by other jurisdictions and banks sharing on a narrow set of regulatory questions (as recently was undertaken with Mexico).

  • Full compliance with international standards on AML/CFT frameworks or the sharing of tax information by other jurisdictions and banks will only help to mitigate the risks U.S. banks face and help alleviate concerns about the adequacy of controls at recipient institutions.

  • There may be mechanisms for U.S. financial intermediaries to lessen the fixed costs of compliance and risk management by pooling resources, utilizing specialist transfer and clearing services, building common platforms, and sharing information on clients. This could be particularly valuable for small states that are on the recipient side but lack scale in their transactions.

  • There may also be scope for U.S. banks to vary more the pricing of correspondent services to factor compliance costs in their fee structure and make the risk-return profile more attractive.

Staff Appraisal

45. Growth and inflation. While the pace of the expansion has disappointed over the past few quarters this is a temporary setback and there are signs healthy growth rates are already resuming in the second quarter. As remaining slack is eroded, and employment continues to expand, wage and price inflation should begin to rise, helping to raise average living standards and reverse some of the loss in labor share of income.

46. External assessment. The U.S. external position is moderately weaker than implied by medium-term fundamentals and desirable policies. Over the medium term, fiscal consolidation and policies to raise productivity, increase the labor force, and raise saving will help maintain external stability while achieving full employment.

47. Supply-side trends. Although near-term prospects for growth are good, over a longer horizon the U.S. is likely to confront significant complications associated with a confluence of factors: aging demographics, polarization of the income and wealth distribution, low productivity, declining labor force participation, a falling labor share of income, compromised dynamism, and high levels of adult and child poverty. Some of these reflect global trends and are likely to have common causes.

48. Supply-side policies. The interlinked and complex nature of the supply-side trends facing the U.S. economy mean that reversing them will require efforts on multiple fronts. These include protections for low income households (through a combination of a higher federal minimum wage, more generous earned income tax credit, and a better safety net), a range of benefits to incentivize work and support families, and efforts linked to infrastructure, education, and trade to raise productivity. Policymakers must recognize there is significant uncertainty about how the various possible policy prescriptions will interact. Also, many of the solutions are legislative in nature and will necessitate building a wide social consensus and congressional action. Efforts to foster broad-based political support and to seek out common ground will be essential. If implemented, though, such measures will not only support U.S. economic well-being but, almost universally, have positive spillover implications for the global economy.

49. Fiscal policy. Congressional action over the past year has reached a compromise on fiscal policies that provides the right amount of fiscal support to the U.S. economy. However, those agreements last only until 2017 and efforts can no longer be deferred on tackling the medium-term problems facing the budget. Fortunately, the options to achieve the needed adjustment are many and can accommodate the needed reduction in the medium-term deficit and also fund the additional fiscal measures to support higher potential growth and diminish poverty.

50. Monetary policy. The Federal Reserve should remain data dependent. There is a clear case to proceed along a very gradual upward path for the fed funds rate. Given the likelihood and severity of downside risks to inflation, the potential for a drift down in inflation expectations, the Federal Reserve’s dual mandate of maximum employment and price stability, and the asymmetries posed by the effective lower bound, the path for policy rates should accept some modest, temporary overshooting of the Federal Reserve’s inflation goal to allow inflation to approach the Federal Reserve’s 2 percent medium-term target from above.

51. Macrofinancial policies. While there are pockets of financial sector vulnerabilities they are unlikely to prove systemic. Nevertheless, there are serious data gaps across various parts of the nonbank system which make it impossible to assess the degree of leverage, vulnerabilities and interconnections in the broader financial system. Work should focus on building a more complete and transparent data landscape of the nonbanks. The administration should oppose any attempt to significantly dilute or backtrack on the important progress made in strengthening the resilience of the financial system.

52. It is recommended that the next Article IV consultation take place on the standard 12-month cycle.

Table 1.

Selected Economic Indicators 1/

(percentage change from previous period, unless otherwise indicated)

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Sources: BEA; BLS; FRB; Haver Analytics; and IMF staff estimates

Components may not sum to totals due to rounding

Contribution to real GDP growth, percentage points

Table 2.

Balance of Payments

(annual percent change unless otherwise indicated)

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Sources: BEA; FRB; Haver Analytics; and IMF staff estimates
Table 3.

Federal and General Government Finances

(percent of GDP)

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Sources: Congressional Budget Office; Office of Management and Budget; and IMF staff estimates Note: Fiscal projections are based on the March 2016 Congressional Budget Office baseline adjusted for the IMF staff’s policy and macroeconomic assumptions. The baseline incorporates the key provisions of the Bipartisan Budget Act of 2015, including a partial rollback of the Sequester spending cuts in fiscal year 2016. In fiscal years 2017 through 2021, the IMF staff assumes that the sequester cuts will continue to be partially replaced, in proportions similar to those already implemented in fiscal years 2014 and 2015, with back-loaded measures generating savings in mandatory programs and additional revenues. Projections also incorporate the Protecting American From Tax Hikes Act of 2015, which extended some existing tax cuts for the short term and some permanently. Finally, Fiscal projections are adjusted to reflect the IMF staff’s forecasts for key macroeconomic and financial variables and different accounting treatment of financial sector support and of defined-benefit pension plans and are converted to a general government basis.

Includes staff’s adjustments for one-off items, including costs of financial sector support

Excludes net interest

Excludes net interest, effects of economic cycle, and costs of financial sector support

Percent of potential GDP

Annex I. Response to Past Policy Advice

Fiscal policy. Public finances remain on an unsustainable path. Over the last few years staff has emphasized the importance of fixing long standing fiscal problems and normalize the budget process. The Bipartisan Budget Acts of 2013 and 2015 were welcome steps. The Bipartisan Budget Act of 2015 suspended the debt ceiling until March 2017 and approved appropriations for 2016 and 2017, lessening fiscal uncertainties. These agreements, however, did not address the sustainability of public finances over the medium term. Staff has advocated adopting a medium-term fiscal consolidation plan to restore long-run fiscal sustainability, stressing that early action is needed to slow entitlement spending. Anchored by such a plan, staff called for expanding the near-term budget envelope through specific measures—including front-loaded infrastructure spending, a better tax system, active labor market policies, and improving educational spending, with these measures funded by offsetting savings in future years. As part of the Bipartisan Budget Act and Protecting Americans from Tax Hikes Act, the authorities did expand the near-term deficit and made permanent various tax measures (including improvements to the EITC, the research and experimentation tax credit, and child tax credit advocated by staff).

Monetary policy. Staff supported the FOMC remaining data dependent and recommended deferring the first increase in policy rates until there were greater signs of wage or price inflation than were evident at the time of the 2015 Article IV Consultation. Based on staff’s macroeconomic forecast, this implied a gradual path of policy rate increases starting in the first half of 2016. Staff has also repeatedly stressed the importance of communication and pointed to scope for enhancing the Fed’s communications toolkit. The Fed did raise rates in December 2015, with little impact on domestic or international financial markets, and continues to judge further increases in the federal funds rate based on incoming data. Communications have repeatedly emphasized that the normalization path will be data dependent and gradual. The Fed continues to maintain a supportive monetary policy and has made significant efforts—in FOMC statements, press conferences, and speeches—to prepare markets for the path toward more normal levels of the policy rate.

Monetary policy and financial stability. Staff has recommended that policy rates should not be used in an effort to either reduce leverage or dampen financial stability risks. Instead, efforts should be targeted toward strengthening the macroprudential framework, developing regulatory tools, and addressing gaps in regulation and supervision. The authorities largely agreed saying that “the jury is still out” on whether such using interest rates for financial stability purposes would be advisable in the U.S. context. They also said there were other tools available to manage emerging risks (such as countercyclical capital buffers or margin requirements). Judging from Fed minutes, financial stability considerations appear not to have been a relevant consideration in recent Fed policy rate decisions.

Financial policies. Based on the 2010 and 2015 FSAPs, staff has recommended multiple steps to tackle financial sector risks, particularly those related to activities in nonbank intermediaries. Substantial progress has been made on the national and global financial reform agenda over the last few years, and many of the policy suggestions have been implemented. These include enhanced capital and liquidity buffers, strengthened underwriting standards in the housing sector, greater transparency to mitigate counterparty risks, as well as progress in collecting more comprehensive information to assess risks. Still, several reforms emphasized by staff remain to be completed, such as addressing remaining vulnerabilities of the money market funds and the tri-party repo market, reducing data blind-spots, better risk management and stress testing of asset managers, enhancing the effectiveness of the FSOC, simplifying the institutional structure for financial oversight, and increasing the resilience of the insurance sector. Annex II provides a fuller summary of progress on FSAP recommendations.

Structural policies. Staff has recommended structural measures to counter the slowdown in potential growth and high poverty rates, including further expanding the EITC, increasing the minimum wage, investing in infrastructure and education, improving the tax system, using active labor market policies, implementing a broad, skills-based approach to immigration reform and capitalizing on the gains from rising U.S. energy independence. The Administration has taken measures to increase wages for employees of federal contractors and some states and localities have increased minimum wages and mandated paid family leave. Building political consensus on a reform of the tax system in the direction envisaged by staff (a less complex system with a broader tax base and lower rates) has made little progress. Support for immigration reform is elusive and there is no plan to raise the gas tax or to introduce a VAT or a carbon tax. However, the recent tax bill whose provisions made permanent the enhanced child tax credit, the American Opportunity tax credit for college tuition, the improved earned income tax credit (expanded to larger families and removing the marriage penalty), and the research and experimentation credit for corporations.

Housing finance. Staff has stressed policy measures to encourage greater availability of mortgage credit, while clarifying the future role of government in housing finance. Administrative measures have been taken to lessen regulatory uncertainties and to transfer risks from the agencies to private investors through market transactions but more could be done in this direction without legislation (see 2015 Selected Issues Paper). Legislative proposals to more fundamentally reshape housing finance have made little headway in Congress.

Annex II. Follow-Up on 2015 FSAP Recommendations

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Annex III. Risk Assessment Matrix1

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Annex IV. Public Debt Sustainability Analysis

The budget deficit in the United States has been reduced significantly over the past few years. Yet, the public debt ratio remains on an unsustainable trajectory over the medium term. Under the baseline scenario, public debt is projected to first stabilize, but then to start rising as aging-related spending pressures on entitlement programs assert themselves and interest rates normalize. Gross financing needs are large but manageable given the global reserve currency status of the United States. A medium-term, credible consolidation plan remains a key policy priority.

Background. Significant fiscal consolidation measures were legislated in 2011–13 to tackle the high public debt ratio, which has doubled at the federal government level since 2007 as a result of the financial crisis and the ensuing recession. The Bipartisan Budget Acts of 2013 and 2015 partially reversed the cuts scheduled to take place in FY2014-2017, replacing them with savings generated through cuts to mandatory spending in later years and, thus, improving the pace and distribution of near-term deficit reduction. On the other hand, the Tax Act of 2015, extended many tax cuts through the medium term and made some permanent, leading to higher deficits in the medium and long term.

Baseline. Staff’s baseline assumes the current laws, except that the automatic spending cuts beyond FY2017 would be partially reversed and replaced similar to the deals reached in the Bipartisan Budget Acts of 2013 and 2015). With these assumptions, the public debt ratio temporarily stabilizes in 2016–18. However, the debt ratio starts rising again owing to the rising interest rates, as well as health care and social security related spending pressures from an aging population. Federal debt held by the public is projected to increase from 75 percent of GDP now to close to 82 percent of GDP in FY2025, with general government gross debt exceeding 108 percent of GDP by FY2025. Overall, despite the substantial deficit reduction achieved so far and the legislated savings in the pipeline, the U.S. public finances remain on an unsustainable trajectory.

Adjustment scenario. The 2015 general government primary balance was −1½ percent of GDP. In staff’s view, aiming for a medium-term general government primary surplus of about ¾ percent of GDP (a federal government surplus of about 1 percent of GDP) would be appropriate to put the public debt ratio firmly on a downward path. The target primary surplus would have to be higher in the long run to bring the debt ratio closer to the pre-crisis levels by 2030.

Debt servicing costs. The fiscal projections benefit from the current favorable interest rate-growth differential. Reflecting accommodative monetary policy and the safe haven status of the United States, real interest rates have fallen well below GDP growth. Under the staff’s baseline, the effective interest rate is projected to rise gradually from the current historical lows and reach about 4¾ percent by 2025 (compared to an average of about 3½ percent over 2005–2015). As a result, real interest rates will become a major debt-creating flow over the medium-term.

A01ufig48

Federal Debt Held by the Public

(percent of GDP, fiscal year)

Citation: IMF Staff Country Reports 2016, 226; 10.5089/9781498358958.002.A001

Source: IMF staff estimates

Realism. Baseline economic assumptions and fiscal projections are generally within the error band observed for all countries. While ambitious, the projected fiscal adjustment is realistic based on the consolidation episodes observed in 1990–2011.

Stress tests. The public debt dynamics are highly sensitive to growth and interest rate assumptions, primarily reflecting the fact that the U.S. public debt ratio already exceeds 100 percent of GDP. An increase of 200 basis points in the sovereign risk premium would mean a debt ratio that is about 15 percentage points above the baseline. If real GDP growth turns out to be one standard deviation below the baseline, the public debt would increase by about 8 percentage points above the baseline. A scenario involving a 1 percentage point slippage in the planned consolidation over the next two years would lead to a debt-to-GDP ratio of 110 percent in 2025. A combined macro-fiscal shock could raise the public debt ratio as high as 132 percent of GDP by the end of the 10-year horizon. An exchange rate shock is unlikely to have important implications for debt sustainability in the United States given that all debt is denominated in local currency and the reserve currency status of the dollar.

Mitigating factors. The depth and liquidity of the U.S. Treasury market as well as its safe haven status at times of distress represent a mitigating factor for relatively high external financing requirements.

A01ufig49

United States: Public DSA–Baseline Scenario

(percent of GDP, unless otherwise indicated)

Citation: IMF Staff Country Reports 2016, 226; 10.5089/9781498358958.002.A001

Source: IMF staff1/ Public sector is defined as general government2/ Based on available data3/ Bond Spread over German Bonds4/ Defined as interest payments divided by debt stock at the end of previous year5/ Derived as [(r - p(1+g) - g + ae(1+r)]/(1+g+p+gp)) times previous period debt ratio, with r = interest rate; p = growth rate of GDP deflator; g = real GDP growth rate; a = share of foreign-currency denominated debt; and e = nominal exchange rate depreciation6/ The real interest rate contribution is derived from the denominator in footnote 4 as r - π (1+g) and the real growth contribution as -g7/ The exchange rate contribution is derived from the numerator in footnote 2/ as ae(1+r).8/ For projections, this line includes exchange rate changes during the projection period. Also includes ESM capital contribution, arrears clearance, SMP and ANFA income, and the effect of deferred interest9/ Assumes that key variables (real GDP growth, real interest rate, and other identified debt-creating flows) remain at the level of the last projection year
A01ufig50

United States: Public DSA–Composition of Public Debt and Alternative Scenarios

Citation: IMF Staff Country Reports 2016, 226; 10.5089/9781498358958.002.A001

Source: IMF staff
A01ufig51

United States: Public DSA–Realism of Baseline Assumptions

Citation: IMF Staff Country Reports 2016, 226; 10.5089/9781498358958.002.A001

Source: IMF staff1/ Plotted distribution includes all countries, percentile rank refers to all countries. Projections made in the spring WEO vintage of the preceding year2/ Data cover annual obervations from 1990 to 2011 for advanced and emerging economies with debt greater than 60 percent of GDP. Percent of sample on vertical axis
A01ufig52

United States: Public DSA–Stress Tests

Citation: IMF Staff Country Reports 2016, 226; 10.5089/9781498358958.002.A001

Source: IMF staff
A01ufig53

United States: Public DSA–Risk Assessment

Citation: IMF Staff Country Reports 2016, 226; 10.5089/9781498358958.002.A001

Source: IMF staff1/ The cell is highlighted in green if debt burden benchmark of 85% is not exceeded under the specific shock or baseline, yellow if exceeded under specific shock but not baseline, red if benchmark is exceeded under baseline, white if stress test is not relevant2/ The cell is highlighted in green if gross financing needs benchmark of 20% is not exceeded under the specific shock or baseline, yellow if exceeded under specific shock but not baseline, red if benchmark is exceeded under baseline, white if stress test is not relevant3/ The cell is highlighted in green if country value is less than the lower risk-assessment benchmark, red if country value exceeds the upper risk-assessment benchmark, yellow if country value is between the lower and upper risk-assessment benchmarks. If data are unavailable or indicator is not relevant, cell is white.Lower and upper risk-assessment benchmarks are:400 and 600 basis points for bond spreads; 17 and 25 percent of GDP for external financing requirement; 1 and 1.5 percent for change in the share of short-term debt; 30 and 45 percent for the public debt held by non-residents4/ An average over the last 3 months, 17-Mar-16 through 15-Jun-165/ Includes liabilities to the Eurosystem related to TARGET

Annex V. External Sector Assessment

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1

The Risk Assessment Matrix (RAM) shows events that could materially alter the baseline path (the scenario most likely to materialize in the view of IMF staff). The relative likelihood of risks listed is the staff’s subjective assessment of the risks surrounding the baseline (“low” is meant to indicate a probability below 10 percent, “medium” a probability between 10 and 30 percent, and “high” a probability between 30 and 50 percent). The RAM reflects staff views on the source of risks and overall level of concern as of the time of discussions with the authorities. Non-mutually exclusive risks may interact and materialize jointly.

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Cover IMF Staff Country Reports
United States: 2016 Article IV Consultation-Press Release; and Staff Report
Author:
International Monetary Fund. Western Hemisphere Dept.
Volume/Issue:
Volume 2016: Issue 226
Publisher:
International Monetary Fund
ISBN:
9781498358958
ISSN:
1934-7685
Pages:
85
DOI:
https://doi.org/10.5089/9781498358958.002

Contribution to Growth

(%pts)

Labor Market Slack 1/

Household Formation and Vacancy Rates

Saving & Net Worth, 1983-2016

(percent)

Decomposition of PCE Elasticity to Lower Energy Prices

(percentage points)

Response of Consumer Confidence to 10% Lower Gas Prices

(index points)

Response of Rates on Auto Lending to 10% Lower Gas Prices

(percent)

REER and Net Exports

Oil Investment and WTI

Growth: Potential and Actual

(percent)

$/Euro Dynamics and Interest Differential

$/Euro Dynamics and Risk Premium

Trade-Weighted Dollar Response to Risk Premium and Interest Differential Shocks

(percent) 1/

Dollar IRFs to VIX Shock

(percent)

Total Production and Production per Rig

Upside Scenario Real GDP, 2021

(% diff.)

Uninsured Rate

(percent of population)
Figure 1.

Financial Conditions

FHA Mortgage Originations

Demographic Shift

Consensus Long-run Growth Forecasts

(%)

US Average TFP Growth

(percent)

Dynamism

(percent)

Income Distribution and Labor Share

Job-to-Job Transition Rate

(percent)

Firm Entry Rates Across Sectors

(percent)

Real Median Family Income by Income Percentiles

(2005$ thousands)

Household Real Net Worth

(percent of 1983 real net worth)

Share of Households by Income

(percent)

Poverty Rates

(percent of total population)

Effective Minimum Wage by State, 2015

Poverty and Social Spending

Labor Force Participation Rate

(percent)

Quality of Infrastructure

(score 1-7 best)

Public Investment, Structures

(% of GDP)

Average PISA Score, 2012

Tertiary Education

Private Services Exports

(US$ billions, 2013)

Federal Debt Held by the Public

(percent of GDP, fiscal year)

Statutory Corporate Tax Rates

(percent)

Policy Rates Expectations

(percent)

Core PCE Inflation

(percent, yoy)

Wage Growth

(percent, yoy)
Figure 2.

Inflation Dynamics

Phillips Curve Shift, 1992-2015

(percent)

Bank Health and Prosperity

(percent) 1/

Impact of Higher Policy Rate on Mortgage Credit

Portfolio Composition

(percent of assets)

Investments

(percent of assets/liabilities)

Federal Debt Held by the Public

(percent of GDP, fiscal year)

United States: Public DSA–Baseline Scenario

(percent of GDP, unless otherwise indicated)

United States: Public DSA–Composition of Public Debt and Alternative Scenarios

United States: Public DSA–Realism of Baseline Assumptions

United States: Public DSA–Stress Tests

United States: Public DSA–Risk Assessment