“The U.S. economic recovery remains modest but is gaining ground, supported by a rebound in the housing market, still easy financial conditions, and a boost to household net worth from higher house and stock prices,” begins a report from the International Monetary Fund released Friday. “These factors are helping to offset the impact of strong fiscal adjustment on consumer spending. But the economy is still far from normal conditions, with high unemployment and a large negative output gap.”
The report echoes much of the same sentiment held by economists at the U.S. Federal Reserve. In line with the IMF’s observations, the July Monetary Policy Review states that real economic activity continues to increase modestly — a key word in descriptions of the economy these days — but fiscal policy has proven to be a strong and sustained headwind.
The Fed, like the IMF, pointed at the housing market as a bastion of the recovery, but was quick to note that the labor market is far from healed. All told, the two monetary policy bodies seem to hold a cautiously optimistic stance, though they both recognize that there are still substantial obstacles to overcome.
“The fiscal consolidation should be more balanced and gradual,” the IMF said. “The automatic spending cuts (sequester) not only reduce growth in the short term but could also undermine potential in the medium term through indiscriminate cuts to education and infrastructure.”
These comments jive with a sentiment that Federal Reserve Chairman Ben Bernanke and others in the U.S. have repeated for the past several years: fiscal policy has become a headwind. Once expansionary policy — characterized by lower taxes like a payroll tax cut and government spending in the form of a stimulus package — has been replaced with cut-throat budget negotiations seen during the so-called fiscal cliff, spending cuts via the sequester, and the expiration of tax holidays.
Generally speaking, expansionary fiscal policy stimulates the economy, and governments typically take an expansionary position during recessions to spur growth even if it means taking on additional debt. Proponents of this strategy would rather grow the economy now and pay back the debt later.
However, as the Economic Stimulus Act of 2008, the American Recovery and Reinvestment Act of 2009, and the Tax Relief Act all wound down toward 2011, policy quickly became contractionary. This shift toward contractionary fiscal policy was assisted by a legislative push to reduce the deficit and balance the federal budget — a well-meaning initiative, but one that the IMF ultimately disagrees with.
The IMF suggests the “indiscriminate cuts to education and infrastructure…should be replaced with back-loaded entitlement savings and new revenues. Even though the fiscal deficit is declining rapidly, approving a plan to restore long-run fiscal sustainability remains a priority. Early action is needed for measures that slow entitlement spending, as their effects build gradually over time.”
“Given the still-large output gap and well-anchored inflation expectations, the highly accommodative monetary policy stance is appropriate,” commented the IMF. “While unwinding monetary policy accommodation is likely to present challenges, including for financial stability, the Fed has a range of tools to help manage the exit.”
Again, this is in line with the Fed’s own assessment of the current position of monetary policy. Given that headline unemployment remains high, at 7.6 percent compared to the Fed’s target of 6.5 percent, and inflation remains below the Federal Open Market Committee’s 2 percent long-run objective, the committee has indicated that a “highly accomodative monetary stance” will remain appropriate for at least the near future.
This means that the federal funds rate, which is used as a benchmark for short-term interest rates, will remain targeted at the zero bound between 0 and 0.25 percent. In addition to this, the committee will continue asset purchases, or quantitative easing, through which the Fed is purchasing $40 billion in agency mortgage-backed securities and $45 billion in longer-term Treasury securities each month in order to put downward pressure on longer-term interest rates.
Quantitative easing has four primary effects on the economy: higher inflation expectations, currency depreciation, higher equity valuations, and lower real interest rates. QE is similar to normal monetary policy in that it puts downward pressure on nominal and real interest rates. The Fed has indicated that asset purchases will be tapered slowly in relation to incoming economic information. Once purchases have ended, perhaps sometime in 2014, then the Fed will begin raising the target federal funds rate.
While the size of the Fed’s balance sheet is concerning to many observers — $3.5 trillion in total assets, 56 percent of which are Treasuries and 36 percent of which are agency securities — the Fed itself and the IMF don’t seem too worried. The Fed has indicated that it will likely hold on to its agency mortgage-backed securities and Treasuries until maturity.
Financial Outlook and Stability
“The protracted period of low interest rates may have raised vulnerabilities in the financial sector, which warrant close monitoring,” the IMF said in its report. “While progress on financial reform has been made, reforms need to be completed in a number of areas. Domestic reforms should be coordinated with the global financial reform agenda, as this would help to reduce fragmentation of the global financial regulatory landscape.”
Specifically, the IMF is referencing the Basel Accords. The implementation rules for Basel III were recently finalized, setting the phase-in deadline for large financial institutions in January 2014 (January 2015 for smaller banks).
The Fed identified the same risk from low interest rates in its MPR report: “While the extended period of low interest rates has contributed to improved economic conditions and increased resiliency in the financial sector, it could also lead investors to ‘reach for yield’ through excessive leverage, duration risk, credit risk, or other forms of risk-taking. There are signs that the low level of interest rates, as well as improved investor sentiment, has contributed to a modest pickup in leverage and maturity transformation in some markets. However, the recent rise in interest rates and volatility may have led some investors to reevaluate their risk-taking behavior.”