The Federal Reserve can afford to keep short term interest rates close to zero for longer than the current market expectation of a first rate hike in the middle of 2015, the International Monetary Fund said Monday, as it forecasts the economy not reaching full employment until over three years from now, while inflation pressures will remain in check.
In the concluding statement following its Article IV consultation with the United States, the IMF argued that “given the substantial economic slack in the economy, there is a strong case to provide continued policy support.” However, it would prefer for the bulk of that support to come from fiscal authorities, allowing for an earlier withdrawal of monetary stimulus by the Fed.
The IMF said that under its staff’s baseline, the U.S. economy is expected to reach full employment only by the end of 2017 and inflationary pressures are expected to remain muted. “If true, policy rates could afford to stay at zero for longer than the mid-2015 date currently foreseen by markets,” the IMF said.
It went on to stress, however, the Fed would have to be on the look out for financial stability risks, particularly those that are inherently difficult to contain through available regulatory and supervisory tools.
“The prolonged period of very low interest rates continues to raise financial stability concerns, particularly related to activities in the so-called ‘shadow’ banks and in other nonbank intermediaries,” the IMF said.
“In particular, a tail risk where there was a precipitous attempt by investors to exit certain markets – perhaps exacerbated by outflows from ETFs and mutual funds as well as near-term market illiquidity – could trigger an abrupt and self-reinforcing re-pricing of a range of financial assets,” the statement said. “This, in turn, could have damaging implications for U.S. growth … and negative knock-on effects internationally.”
Still, “If inflation were to rise more rapidly than expected and the economy was still well below full employment, tolerating a modest, temporary rise of inflation above the longer – term goal could be consistent with the Fed’s balanced approach as long as inflation expectations remain anchored and financial stability risks were low,” the IMF said.
The statement noted that the Fed is faced with multiple areas of uncertainty: the amount of slack remaining in U.S. labor markets; the effect this is having on future wage and price inflation; and the transmission to the real economy of a future move upwards in policy rates.
“These substantive ambiguities make the outlook for U.S. monetary policy particularly uncertain,” the IMF said, something that “stands in contrast to the narrow range of market views on the path for future policy rates as well as the current historically low pricing of asset price volatility.”
“At the same time, longer-term treasury yields and the term premia have been compressed to very low levels,” the IMF continued, “this sets up the risk, even with a successful and well-communicated increase in interest rates, for significant swings in market flows and prices in the months ahead. If such volatility were to unfold, it would have implications that would reach far beyond U.S. borders , potentially straining those countries with weaker fundamentals which could then have second round effects for U.S. growth.”
The IMF cautioned that longer-run U.S. growth is likely to average around 2% for the next several years, down from the projection made in the last Article IV consultation. The labor markets are weaker than what is indicated by the current 6.3% unemployment rate, it said, with high long-term unemployment, stagnant wages, and a low labor force participation rate that is not just the result of demographic factors.
Recent economic data suggest “a meaningful rebound in activity is now underway and growth for the remainder of this year and 2015 should well exceed potential,” the statement said, but this will only partially offset the weak first quarter. So 2014 growth is now projected at 2%, rising to 3% in 2015.
In addition, “limited availability of mortgage financing is a pressing constraint on economic growth,” the IMF said.
The IMF also renewed its concerns about the fiscal situation in the U.S., noting that general government debt is still not on a sustainable path, “and is likely to begin rising again by 2018.”
“The recent experience of debt ceiling brinkmanship and the government shut down once again illustrates the potential economic damage from political discord linked to fiscal policies,” it said, “there is a risk that, in the Spring of 2015, many of these issues will come to the fore once more.”