“...we share a common commitment to a medium-term strategy: credible fiscal consolidation programs, successful anti-inflationary policies...”.
The US Federal Reserve has had successful year in meeting this commitment. However, the recent reluctance of the Federal Reserve to raise rates despite the strong output growth figures has raised the risk of a resurgence of inflation.
The growth in the consumer price index averaged 2.9% in 1996, up from 2.8% in 1995 and 2.6% in 1994. By December 1996, the year over year growth in the CPI had topped 3%, but has since moderated nearer to 2.5%. The IMF expects inflation in 1997 to average 2.9%. The difficulty in evaluating the inflation performance of the US is that the US Federal Reserve does not have any explicit inflation targets. Instead, it has an unofficial policy of ‘opportunistic dis-inflation' aiming for price stability. The recent behaviour of the US Federal Reserve points to an implicit CPI inflation target ceiling of 3%.
What constitutes price stability is debatable but it is widely agreed that it is more than zero inflation. The Boskins Commission has recently argued that the measure of the CPI in the US may well over overstate price inflation by up to 1.1% per year - a figure that has come under criticism for being too high. This is due to the failings of the index to account for substitutions to cheaper alternatives and to account for quality improvements. Consequently, allowing for some room for downside risk, the Federal Reserve is unlikely to consider it desirable for inflation to fall below 2%..
An important development in the past year was the announcement by the US Treasury in May 1996 of its intention to issue real indexed government bonds. Here the US Treasury guarantees the holder of the bond, not a nominal rate of return, but a real rate of return. The nominal rate of return is therefore set ex post after the rate of inflation has been publicized. Although issued for a number of reasons, the bond provides a encapsulation of market inflationary expectations. It therefore provides a very useful indicator of the credibility of the monetary authorities commitment to maintaining low inflation.
Until March 1997, Federal Reserve monetary policy had been accommodative, successfully offsetting the restrictive federal fiscal policy. The Federal Reserve has been very successful in maintaining the ‘goldilocks' economy through 1996: moderate growth, low unemployment and inflation within target. Although quarterly output growth rates oscillated through 1996, the year over year growth remained at or below 2% until the fourth quarter. The unemployment rate ranged between 5-5.5% and the CPI inflation rate until the fourth quarter stayed below 3%.
There has been some concern over the unusually low levels of unemployment, since this is normally associated with higher inflation. According to the IMF estimates, the US economy is the only economy in the G7 in which the level of economic activity is not significantly below potential - which does not have a negative output gap. On the contrary, the IMF estimates that in 1996 the US economy operated about 0.5% above potential - the third successive year of positive output gaps. This is consistent with the IMF view estimate of the non-accelerating rate of unemployment between 5.5-6%. The absence of accelerating inflation through 1996 supported the view of the Federal Reserve that the level of unemployment normally associated with accelerating inflation may well have declined.
In recent months, however, there has been mounting concern over the risk of inflation resurging. The US economy in the first quarter and into the second quarter has continued to outpace expectations and the consensus for real GDP growth for 1997 has been revised upwards: the IMF has projected growth to reach 3%, while WEFA expects growth to top 3.5%, possibly reaching 4%. Moreover, the IMF expects the output gap in 1997 to widen to 1.2%. Despite these strong growth figures, the Federal Reserve has declined to move decisively. It did raise rates by 25 basis points in March as pre-emptive move against inflation but declined to raise rates again in the May meeting of the FOMC. On the contrary, the US Federal Reserve has signalled that it has shifted from a symmetric bias towards raising rates towards a symmetric neutral position. This is because there is still no evidence of inflation and the Federal Reserve expects growth to moderate later in the year thereby moderating any potential build-up in inflationary pressures.
(b) Fiscal consolidation - score +1
The US federal government in conjunction with Congress has made considerable progress in reducing the federal deficit. The recent provisional budget agreement has changed the time profile of the deficit. Under existing policy, the deficit could have been eliminated perhaps as soon as fiscal 1998, but with the expectation of a subsequent resurgence in the deficit due to Medicare costs. The new agreement postpones the elimination of the deficit to 2002 but addresses, if only temporarily, the longer term concerns over Medicare costs. The new agreement does not address concerns over the longer term viability of Social Security.
The unified federal deficit has declined significantly over the past five years. It has declined from $290 billion (4.9% of GDP) in fiscal 1992 to $163 billion (2.2% of GDP) in fiscal year 1995 and to $107 billion (1.4% of GDP) in the fiscal year 1996.. The CBO's projected unified deficit for fiscal year 1997 point to another significant decline to $67 billion (0.7% of GDP). The 1997 deficit is considerably below the $153 billion deficit expected in the June 1996 Congressional budget resolution. The significant improvement in the federal deficit has been driven by the October 1990 Budget Enforcement Act (BEA) and the August 1993 Omnibus Budget Reconciliation Act (OBRA93) and more recently by the positive impact of the cyclical recovery in the economy on tax revenues.
The BEA replaced annual deficit ceilings with caps on discretionary outlays. It also added the ‘pay-as-you- go' provision which required that changes in taxes or mandatory programs not add to the deficit. Despite these measures, the deficit deteriorated between 1990 and 1993 due to the rapid growth of entitlements, the cost of resolving the loans and savings crisis and the effect of the economic slowdown.
The OBRA93 was introduced as a response to this downturn. The OBRA93 envisaged cumulative deficit reduction of about $500 billion over fiscal 1994-98. The OBRA93 confirmed the BEA but also introduced significant tax increases and expenditure cuts. The Act introduced large tax increases on higher income taxpayers, corporations and on gasoline consumption. It also introduced large expenditure cuts on both discretionary and mandatory spending.
Both Congressional and Administration support for deficit reduction has intensified since 1994, with differences focusing on the speed of reduction and the magnitude of tax cuts. Unable to find any ground for agreement, the budgets over the past two years have been characterized by gridlock with no major fiscal policy initiatives introduced.
A shift of policy stance was signalled in the recent budget agreement reached on May 16, 1997 for fiscal year 1998. The budget agreement continues to curtail expenditure growth by extending the expenditure caps and the pay-as-you-go provisions through to 2002. It introduced further expenditure savings with a $100 billion reduction in discretionary spending over five years. The budget also temporarily addressed concerns over Medicare with savings of about $115 over five years, thereby extending the solvency of the plan for another ten years. However, the budget also introduced tax cuts of $85 billion in net tax relief and up to $135 billion in gross tax relief over five years. The tax measures include child tax credit, death tax relief, expanded IRA's (Individual Retirement Accounts), and capital gains tax relief.
The budget projects the elimination of the deficit by fiscal year 2002. The agreement projects the deficit to rise from $67 billion in fiscal 1997 to $90 billion in fiscal 1998 and staying over $80 billion through to fiscal 2000. Only then is it projected to trail downwards rapidly to a surplus by 2002. Most of the deficit reduction is therefore back-loaded towards the end of the forecast horizon. This is because the budget agreement front- loads the tax cuts and back-loads the discretionary expenditure cuts.
WEFA estimates that under the existing policy, and in the absence of the new agreement, the deficit would have been eliminated perhaps as soon as fiscal 1998. However, the rise in Medicare costs would have resulted in the resurgence of the deficit early in the next decade. The new agreement (temporarily) addresses concerns about Medicare but at the cost of postponing the elimination of the deficit. An important note is that the new agreement only postpones the insolvency of the Medicare plan for a decade. Moreover, it does not address the projected insolvency of the Social Security plan.
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