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FINANCIAL CHRONICLE™ » DAILY CHRONICLE™ » Modest US recovery, but Europe a key risk

Modest US recovery, but Europe a key risk

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1Modest US recovery, but Europe a key risk Empty Modest US recovery, but Europe a key risk Thu Jul 05, 2012 12:35 am

Redbulls

Redbulls
Director - Equity Analytics
Director - Equity Analytics
* U.S. economy expected to grow by 2 percent in 2012 as strains in Europe intensify = Key challenge is to manage pace of deficit reduction without hurting economy = Progress made but more efforts needed to increase resilience of U.S. financial system

The U.S economy continues to recover at a tepid pace, while concerns about the euro area debt crisis and uncertainty over domestic fiscal plans are creating a challenging environment for the world’s largest economy, the IMF said after wrapping up its annual review of the U.S. economy.

An IMF team, led by Gian Maria Milesi-Ferretti, Assistant Director of the Western Hemisphere Department, met with Treasury Secretary Timothy Geithner, Federal Reserve Chairman Ben Bernanke, and other senior U.S. officials from May 21 to July 2 to conduct the annual review.

"The United States remains vulnerable to contagion from an intensification of the euro area debt crisis, which would be transmitted mainly via a generalized increase in risk aversion and lower asset prices, as well as from trade channels" said IMF Managing Director Christine Lagarde during a press conference in Washington, D.C.

On the domestic front, failure to reach an agreement on near-term tax and spending policies would trigger a severe "fiscal cliff" in 2013, threatening the recovery, she added. Lagarde made these remarks after joining the final policy discussions.

The IMF expects U.S. growth to remain modest during the next two years, constrained by housing difficulties, the expiration of fiscal stimulus measures, and continued low global demand, particularly in Europe. Growth is projected at 2 percent in 2012 and about 2¼ percent in 2013.

The main policy challenge is to use the limited policy space to support the recovery in the near term, while restoring medium-term fiscal sustainability and completing financial sector reforms. The crisis and ensuing recession significantly worsened the state of U.S. public finances and exposed vast gaps in the financial and regulatory frameworks, the IMF said.

Avoiding the "fiscal cliff"

The IMF stressed that it is critical to remove the uncertainty created by the "fiscal cliff" in 2013—when temporary tax provisions expire and automatic spending cuts take effect. Should the fiscal cliff materialize, the IMF warned that it could have severe consequences for domestic growth. The authorities therefore need to ensure that the pace of deficit reduction does not sap the economic recovery. The IMF also raised the importance of promptly raising the debt ceiling to forestall the risk of financial market turmoil.

At the same time, the IMF said that a comprehensive and credible fiscal consolidation plan is crucial to ensure that the public debt-to-GDP ratio stabilizes by mid-decade and gradually falls afterwards.

Given the size of the budget deficit, age-related spending pressures, and the relatively low tax ratio, the fiscal consolidation effort would need to rely on both higher revenues and cuts in entitlement spending. Some options include health care and Social Security reforms, reducing tax expenditures, and possibly introducing a value-added tax and carbon taxes.

Supporting the recovery

With inflation kept in check by the sizeable economic slack, and unemployment projected to decline only slowly, the IMF supports the Federal Reserve’s intention to keep the monetary policy stance accommodative for an extended period. Should the outlook worsen, a number of tools could be used for further easing, including through additional purchases of mortgage-backed securities.

Removing distortions

The IMF stressed the need for more aggressive efforts to accelerate the resolution of the housing crisis. These include measures to facilitate the conversion of foreclosed properties into rental units and supporting access to refinancing on a larger scale. Another option would be to allow mortgages on principal residences to be modified in personal bankruptcy without secured creditors’ consent ("cram-downs").

At the same time, the IMF said that measures are needed to reduce the risk that long-term unemployment could morph into higher structural unemployment and reduce potential output. Active labor market policies, such as training and support for job search, should therefore be adequately funded.

Regulation of the financial sector

Good progress has been made in reforming the U.S. financial system, but vulnerabilities remain, the IMF said.

Four specific areas were highlighted for further progress:

• Regulation of the shadow banking system: Given the size of the industry and prominence in short-term funding, strengthening regulation of Money Market Mutual Funds remains critical.

• Volcker rule: A ban on proprietary trading by banks should, in principle, reduce systemic risk.

• Housing finance: Measures to help the recovery of private securitization would ease mortgage market conditions.

• Funding for regulatory agencies: Adequate implementation of domestic and international reforms requires appropriate funding to the regulatory and supervisory agencies.

Global spillovers…

As the world’s largest economy, the policy actions of the U.S. have significant effects on global growth and stability. Striking the right balance between fiscal consolidation and economic policy support would benefit the rest of the world, as it would avoid the risk of a spike in U.S. interest rates and an abrupt decline in U.S. growth in 2013. Further progress in implementing financial reforms would also be globally beneficial and reduce the scope for regulatory arbitrage.

A final report will be issued once it has been discussed by the IMF’s Executive Board in late July.

(IMF Survey)
http://www.island.lk/index.php?page_cat=article-details&page=article-details&code_title=55979

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