Journal Issue

In the News: U.S. Economy Appears Headed for a Soft Landing, but Long-Term Fiscal Sustainability Remains a Challenge

International Monetary Fund. External Relations Dept.
Published Date:
August 2006
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Despite monetary policy tightening, higher energy prices, and significant hurricane damage in parts of the country, the U.S. economy continued to be a key engine of global growth in 2005. For the near term, a soft landing to growth at a more sustainable rate appears likely, but the country’s long-term fiscal outlook remains unsustainable. The key challenge ahead, according to the IMF’s annual Article IV consultation on the economy, will be to put Social Security and, in particular, Medicare and Medicaid, on a durable footing.

Real GDP in the United States grew by 3.2 percent in 2005, reflecting robust consumer spending and business investment. Personal consumption was supported by significant borrowing encouraged by low interest rates and by modest employment growth. Since 2001, sizable capital gains—reflecting, in part, double-digit house price inflation—have boosted personal wealth, allowing real consumption and residential investment spending to grow at an average ½ of 1 percentage point faster than GDP. As a result, the household saving ratio moved into negative territory in 2005.

Prospects for the U.S. economy in 2006 remain favorable (see table), with the IMF staff projecting real GDP growth to ease to a more sustainable pace of about 3 percent in 2007. This soft-landing scenario is based on expectations of solid productivity growth, robust business investment, and faster external growth. Concerns remain, however, about the downside risks from the housing market, which has weakened in 2006. A more abrupt slowdown in the housing market and higher energy prices could trigger a sharper adjustment in household consumption, undermining the expansion.

Emerging pressures

The sustained growth of recent years has reduced economic slack and, with significant hikes in commodity prices, caused inflationary pressures to emerge. In particular, the unemployment rate—at just over 4½ percent in June—is at the low end of most estimates of the NAIRU (the nonaccelerating inflation rate of unemployment), capacity utilization has reached its long-run average, and core consumer price inflation exceeded 2½ percent in the 12 months to June. On the other hand, increases in unit labor costs through the first quarter were moderate, reflecting solid productivity growth and modest wage gains.

After an unbroken series of 17 interest rate hikes, the U.S. Federal Reserve recently left the interest rate unchanged and cautioned that the pace and timing of future rate adjustments would be less certain. The Federal Open Market Committee noted that “the extent and timing of any additional firming that may be needed…will depend on the evolution of the outlook for both inflation and economic growth. . . .” In this context, the committee also said that risks to inflation remain, reflecting high levels of resource utilization and the potential for greater pass-through of elevated commodity (especially energy) prices.

Indeed, the recent increase in core inflation and the decline in the unemployment rate underscore the upside risks to inflation. The IMF staff found the gradual withdrawal of monetary stimulus over the past year to be appropriate and observed that, in the year ahead, the Federal Reserve would need to steer a delicate course between competing risks.

The U.S. current account deficit reached a new high of 6.4 percent of GDP in 2005, reflecting both higher oil prices and solid import demand. Nonetheless, the dollar remained broadly stable, and the U.S. net foreign liability position barely deteriorated in 2005 owing to the relative strength of foreign equity markets.

At the same time, staff observed that the real exchange rate appeared overvalued given macroeconomic fundamentals. Concern remained about the risks of a “disorderly” correction to the current account imbalance. To help minimize these risks, staff urged the United States to raise national saving—including through more ambitious fiscal consolidation—in conjunction with steps toward greater exchange rate flexibility in emerging Asia and growth-enhancing reforms in Europe and Japan.

Economic expansion continues

U.S. growth has remained steady in the face of head winds, but inflationary pressures are emerging.


(percent change)
Real GDP11.
Consumer price index1.
(percent of labor force)
Unemployment rate5.
(percent of GDP)
Federal government balance (fiscal year)-1.5-3.5-3.6-2.6-2.3
Current account balance-4.5-4.8-5.7-6.4-6.4

This table reflects data available after the publication of the IMF staff report on the United States, including revisions to national accounts data showing lower growth for 2003-05.

Data: Haver Analytics and IMF staff projections.

This table reflects data available after the publication of the IMF staff report on the United States, including revisions to national accounts data showing lower growth for 2003-05.

Data: Haver Analytics and IMF staff projections.

Resilient financial sector

The U.S. economy has been able to sustain impressive growth and finance its current account deficit through access to foreign saving at relatively low rates. In this effort, the country’s remarkably innovative and resilient financial sector has played a key role. In particular, financial market innovation—including securitization and credit risk transfer techniques—has contributed to low credit risk spreads and improved pricing and credit allocation, especially for asset classes with higher risk profiles. Banks also remain well capitalized and highly profitable despite challenging market conditions.

The financial sector appears well positioned as the credit cycle turns, but further reforms could enhance the system’s resilience and efficiency. These reforms include tightening the supervision of government-sponsored enterprises like the Federal National Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage Corporation (Freddie Mac) and limiting the size of their balance sheets; reforming rules for defined-benefit pension plans; and, possibly, consolidating the supervision and regulation of insurance companies.

Over the longer term

On the fiscal side, robust revenue growth and, to a lesser extent, expenditure discipline have improved prospects. Both personal and corporate tax receipts have recently exceeded projections by a wide margin, and all indications are that this year’s federal deficit will fall below 2½ percent of GDP—down from over 3½ percent in 2004. However, the permanence of the revenue buoyancy remains to be seen, and significant pressures for higher spending persist despite moderate success in constraining nondefense discretionary expenditure in 2005.

Despite the improved medium-term outlook, the long-term fiscal path remains unsustainable (see chart). The IMF staff and U.S. officials agree that far-reaching reform of entitlement programs (including Social Security and Medicare) is needed to restore fiscal sustainability. The FY2007 budget estimates that spending on entitlement programs will rise by about 1½ percent of GDP each decade through 2080, as population aging and rising health care costs place an increasing burden on public retirement and health care systems. U.S. health care spending is around 15 percent of GDP—well above the industrial country average—with the public sector responsible for half the total. Moreover, overall costs continue to rise more quickly than nominal GDP.

Challenging fiscal outlook

Even with entitlement reforms, the deficit will be unsustainable without further fiscal adjustment.

(long-run federal projections, percent of GDP)

Data: U.S. Congressional Budget Office.

A key challenge for policymakers will be to form a bipartisan consensus on a package of reforms that can make these entitlement programs more sustainable. The administration has offered proposals to reform Social Security—including progressive price indexation, which maintains a larger share of the benefits of lower-income beneficiaries—but legislative efforts in Congress appear to have stalled. The administration’s health care strategy combines high-deductible health savings plans with improved information on the quality and effectiveness of medical procedures and services. However, the financial shortfall of the Medicare and Medicaid programs dwarfs that of Social Security, and a broader, more fundamental reform of Medicare and Medicaid seems necessary.

With economic expansion having recently narrowed the deficit, the IMF staff views the present time as particularly appropriate for the administration to establish a more ambitious medium-term fiscal anchor to support long-run fiscal sustainability. In particular, staff research suggests that balancing the budget—excluding the Social Security surplus—within the next five years would set the federal debt ratio on a downward path. Given current budget projections, consolidation of about ¾ of 1 percentage point of GDP a year would be necessary. Together with entitlement reform, this would be an important step toward long-term fiscal solvency. This policy would have a manageable effect on U.S. and global demand, and, by boosting national saving, it would facilitate multilateral efforts to reduce global imbalances.

Sam Ouliaris and Andrew Swiston

IMF Western Hemisphere Department

Copies of United States: 2006 Article IV Consultation, IMF Country Report No. 06/279, are available for $15.00 each from IMF Publication Services. See page 256 for ordering details. The full text is also available on the IMF’s website (

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