The IMF’s U.S. team recently conducted its annual checkup of the U.S. economy, known as the Article IV consultation. Head of the U.S. team, Gian Maria Milesi-Ferretti, speaks about the risks hampering a recovery, how the government has been managing the U.S. economy, and when we should expect the housing market to turn around.
Q: What is the outlook for the U.S. economy?
Milesi-Ferretti: We expect the U.S. economy to recover at a tepid pace in 2012 and 2013—at about 2 and 2¼ percent, respectively—in line with the very slow recoveries that we have seen in previous financial crises and housing busts.
But the outlook remains difficult. With house prices still weak, households are rebuilding their wealth by reducing debt, and therefore consumption growth will remain sluggish. Exports have been a bright spot in the recovery but going forward they are going to be restrained by weaker growth in trading partners and the stronger U.S. dollar. And the inevitable correction of the very large U.S. fiscal deficit will mean less spending and more taxes starting in 2012.
Unfortunately, we also see negative risks, in particular from a further deterioration of the euro debt crisis, as this would lower the demand for U.S. exports and hurt financial markets. The economy would also suffer if policymakers here in the United States were unable to reach agreement on raising the debt ceiling and avoiding the so-called fiscal cliff—the spending cuts and large-scale expiration of tax breaks that will kick in on January 1, 2013 if nothing is done.
But there could also be positive surprises if, with a less uncertain environment, the housing market were to pick up steam and firms were to ramp up their spending and hiring plans.
Q: How concerned are you about the fiscal cliff?
Milesi-Ferretti: Policymakers should address the policy uncertainties related to the fiscal cliff as soon as possible. If the fiscal cliff materializes, the economic effects would be severe, as the U.S. economy would contract in early 2013 and negative spillovers would be felt around the world. Some unfavorable effects from the fiscal cliff could be felt later this year, as consumer and business spending may be held back by the uncertainty about tax rates and government spending levels.
In our view, the best thing that policymakers can do before the year-end is to reach agreement on a medium-term plan to reduce the debt to more sustainable levels through a gradual reduction of the deficit. In addition, the federal debt ceiling should be raised well ahead of the deadline, to alleviate the risks of financial market disruptions and a loss in consumer and business confidence.
Q: With the federal funds rate near zero, what more can the Fed do to help the recovery?
Milesi-Ferretti: Since late 2008, the Fed has adopted unconventional monetary policy measures—as opposed to the more traditional changes in the policy interest rate—to help normalize financial markets and support the economic recovery. These measures have included sizable purchases of U.S. government bonds as well as mortgage-backed securities issued by Fannie Mae and Freddie Mac, with the purpose of lowering long-term interest rates and mortgage rates. The Fed has also indicated its commitment to keep the policy rate low for a long period of time—at least until the end of 2014.
Now, given the already exceptional low levels of interest rates, the room for further monetary easing is limited, but the Fed still has a few options to further support economic activity if needed. For example, the Fed could purchase even more securities, as this would lower interest rates further as well as encourage investors to purchase riskier assets, including equities, thereby easing financial conditions and providing a boost to stock market valuations. The Fed could also announce that the policy rate will remain low for a longer period beyond 2014.
Q: House prices remain weak. When should we expect the housing sector to turn around?
Milesi-Ferretti: While there is little doubt that house prices are still weak, despite the current very low level of interest rates, the trend may finally be turning as house prices have been increasing in the first six months of 2012. And housing starts and sales have been improving since late summer 2011, albeit from very low levels.
We expect these improvements to continue in the future, with the housing market slowly but steadily recovering from the depth of the crisis. In particular, higher affordability should provide a boost to home purchases, although the large stock of houses that are likely to end up in distressed sales is likely to slow the recovery in house prices. At the same time, a rising rate of new households—which declined significantly during the slump—would imply higher demand for housing and thereby sustain the increase in construction activity going forward.
Overall, we project housing activity to return to its average, pre-boom levels some 4–5 years from now.
Q: What will it take to bring about robust job creation and a significant decline in unemployment?
Milesi-Ferretti: The weak labor market is a reflection of a still-weak recovery. We see high unemployment as primarily a cyclical phenomenon—for example, about half of the sharp drop in the labor force participation rate since the onset of the recession is estimated to be related to the weakness in economic activity, which pushes individuals to opt for more schooling or to temporarily drop out of the labor force. Hence, robust growth—significantly in excess of potential output—would be needed to substantially strengthen job creation and reduce the still elevated unemployment and underemployment rates.
A faster pace of economic recovery than experienced so far will not only allow the current pool of unemployed and underemployed individuals to find jobs, but will also reattract into the labor force a large number of those who have stopped looking for an occupation since the onset of the crisis.
At the same time, policies that help long-term unemployed find a job, such as training and job search assistance, would help preserve the stock of human capital and therefore reduce the risk that unemployment would remain higher than precrisis rates even as the economy recovers.
Q: How exposed are U.S. banks to the crisis in Europe?
Milesi-Ferretti: U.S. banks have only a limited direct exposure to countries in the euro area periphery—that is, if we only look at their loans to these economies. This exposure is somewhat greater if we also consider their indirect relationship to banks and firms in these countries, through guarantees and credit derivatives.
In contrast, U.S. banks have more substantial interconnections with the large banks from the core euro area countries and the United Kingdom. They could therefore be affected both by problems in core euro area banks, whether caused by a deteriorating situation in their countries or by the spillovers of problems in the euro area periphery to which such banks are exposed.
More generally, a situation of global financial market turmoil would be bad for U.S. banks through a general market contagion channel, including greater global risk aversion, financial market volatility, and lower global asset prices.
Q: Will the United States still be able to play the role of main engine for global growth?
Milesi-Ferretti: Fiscal consolidation and household deleveraging are likely to continue to slow the U.S. recovery in the near future. Therefore, the U.S. contribution to global demand will be lower than what we saw before the financial crisis.
So while the U.S. heals from the effects of the financial crisis, other countries, in particular those with large current account surpluses, will need to step up and provide a greater contribution to global demand. A rebalancing of demand along these lines will reduce the vulnerabilities exposed by the crisis and contribute to a faster and more sustainable growth rate for the global economy.
(Courtesy IMF Survey)