Country Report United States
The US economic recovery is expected to continue this and next year, but growth will remain below trend. The underlying pace of activity is picking up but the elevated level of uncertainty is holding the recovery back. The brinkmanship in Washington has not resulted in a fiscal crisis yet. Should the Democrats and the Republicans disagree about raising the debt ceiling in the Summer, the US government may eventually be forced to default and this will have serious macroeconomic repercussions. Over the medium-term, the US must address its budget deficit and current account deficit. The country continues to benefit from safe-haven capital inflows and the dollar’s role as the reserve currency. However, worsening macro fundamentals cannot be ignored indefinitely.
The fiscal cliff was partly avoided…
The US economic prospects improved following the decision to partly avoid the fiscal cliff, which could potentially have pushed the economy into a recession in 2013 . However, the ongoing political gridlock combined with contractionary fiscal policy will hold back the US recovery this year. The good news is that the underlying pace of activity is picking up in speed. Once the fiscal uncertainties have cleared, there is a lot of pent-up investment demand waiting to be unleashed and that should also be accompanied by stronger employment growth. Consumers may also spend more given the bottoming out of the US housing market (figure 1). The fact that private sector deleveraging in the US is at an advanced stage and net worth is rising (figure 2) allows households to slightly loosen their purse strings as soon as they regain confidence. Meanwhile, the Fed will continue to support the recovery with extremely loose monetary policy.
 ^ On January 1, the US congress approved a bill to make the Bush tax cuts permanent for individuals with an income below USD 400K, and households below USD 450K. The expiry of the payroll tax break and the termination of the Bush tax cuts for higher incomes went into effect immediately. The postponed automatic spending cuts (USD 85bn in 2013) also took effect on March 1. The Congressional Budget Office estimates that the cuts will shave around 0.6%-points off growth this year and reduce employment by 750,000.
…but the US political deadlock is still unresolved
The credit risk metrics of the US will deteriorate substantially if the Democrats and the Republicans fail to find common ground when the debt ceiling is hit on May 19. The US Treasury is likely to announce ‘extraordinary measures’ to delay a sovereign default by around two months. Even though we believe that a ‘tail-risk’ event (an outright default) will eventually be avoided given the enormous economic and political costs, the brinkmanship in Washington may weigh on private sector confidence and hold back the recovery until mid-2013.
Long-term fiscal risks are not addressed
Even if the debt ceiling is raised, the US will still face high medium-term risks to fiscal sustainability. At 8.5% of GDP in 2012, the general government deficit remains very high. The IMF expects the general government gross debt-to-GDP ratio to peak at 109% in 2014. What’s more, the country as a whole will remain dependent on foreign financing given the still sizeable current account deficit (3% of GDP in 2012).
Despite the steep rise in public sector borrowing and formidable fiscal challenges ahead, government bond yields are still very low from an historical perspective (figure 3). The US is still benefitting from the special role of the dollar and the country’s public debt continues to serve as the world’s risk-free benchmark. As long as the eurozone remains mired in a crisis and the US Treasury bonds are perceived as safe haven assets, long-term interest rates will remain in check and this will, in turn, lead to favourable debt dynamics. However, the extended period of low interest rates seen up until now, if not managed correctly, can potentially lead to consumer/asset price inflation. What’s more, the lesson from the European crisis is that a sudden loss of confidence in public sector debt can sharply push up interest rates, which challenges debt sustainability. Though not our baseline scenario, the state of US public finances and the political deadlock has the potential to weaken investor confidence at some point in time. Of course, Fed intervention through large purchases of public debt securities, as it has until now (figure 4), can keep interest rates low but this may eventually stoke inflation and undermine the central bank’s inflation fighting credentials. Thus, the monetization of budget deficit by the Fed must not be taken for granted.