–With Early Plan, Can Attune Pace of Adjustment to Econ Cycle
–Fed Monetary Accommodation,Asset Purchases,Appropriate for Some Time
–Downside Risks to US Outlook Have Increased

By Heather Scott

WASHINGTON (MNI) – The U.S. government’s debt dynamics are
“unsustainable,” and require an early political deal on a multi-year
fiscal adjustment that is sensitive to the short-term economic weakness,
and “of course” includes rapid agreement to increase the debt limit, the
International Monetary Fund said Wednesday.

In the annual review of the U.S. economy, known as the Article IV
report, the IMF warned that failure to increase the debt ceiling would
risk “severe shock” to the economy and to global financial markets.

And loss of fiscal credibility also would be “extremely damaging,”
while a rapid agreement on a fiscal plan would allow the government to
make less front-loaded cuts, and be more supportive of the recovery, the
IMF said in the unusually prescriptive report.

The report stressed: “And of course, the federal debt ceiling
should be raised expeditiously to avoid a severe shock to the economy
and world financial markets.”

“Fiscal policy consolidation needs to proceed as debt dynamics are
unsustainable and losing fiscal credibility would be extremely
damaging,” the IMF said. “However, the pace and composition of
adjustment should be attuned to the cycle.”

The report noted the slow pace of recovery, and the recent
weakness, and said growth is likely to continue at a modest pace as
private demand recovers slowly.

“The main policy challenge is to implement a substantial and
durable fiscal consolidation effort while ensuring that the
still-fragile recovery remains on track. With public debt on an
unsustainable trajectory, the priority is to stabilize the debt ratio by
mid-decade and gradually reduce it afterwards, consistent with the
administrations objectives,” the fund said.

An “early political agreement on a comprehensive medium-term
consolidation plan” is the “cornerstone of a credible and cyclically
appropriate fiscal adjustment strategy.”

And the IMF said that “with a well-defined multi-year plan in
place, the pace of deficit reduction in the short run could be more
attuned to cyclical conditions without jeopardizing credibility.”

The fund repeated its projections from the World Economic Outlook
released earlier this month, for growth of 2.5% this year and 2.75% in
2012, but cites increased downside risks including the housing
difficulties, the fiscal uncertainty, possible further commodity price
shocks, and tight credit supply.

The IMF said there is “merit” in looking at housing policies “since
they are central to the slow recovery and pose a critical risk. Allowing
for the terms of residential mortgages to be changed in courts
(‘cramdowns’) would create incentives for voluntary modifications.”

And the persistent high U.S. unemployment calls for attention,
including consideration of consolidating disparate federal and state job
programs, to make them more effective and provide better financing.

The Federal Reserve’s monetary policy accommodation, including
asset purchases, will continue to be needed, the IMF said.

“With subdued inflation prospects and ample resource
underutilization, the extraordinary monetary policy accommodation will
likely remain appropriate for quite some time.”

However, the Fed must “remain vigilant to the risk of an unmooring
of long-term inflation expectations, and respond decisively should the
risk materialize in either direction,” the report said.

It added, “the speed and timing of future actions should depend on
incoming data on core inflation, long-term inflation expectations, and
growth, with scope for cushioning the effect of fiscal consolidation on
demand through a more back-loaded withdrawal of monetary stimulus.

“When appropriate, a gradual unwinding of the Fed’s balance sheet
by ceasing the reinvestment of maturing securities seems to be a
reasonable first step in normalizing monetary conditions.”

The IMF noted the U.S. financial system, while healing, remains
vulnerable, and raised concern about “headwinds” to implementation of
the Dodd-Frank reforms.

“Prolonged delays or outright failures in addressing the regulatory
gaps revealed by the crisis, in an environment of plentiful liquidity
and increased financial concentration, could feed another very dangerous
buildup in systemic risks,” the report said.

** Market News International Washington Bureau: 202-371-2121 **

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