IMF Says No US Rate Cuts Unless Economy Slows 'Rapidly'

With a US soft landing of moderate growth and cooling inflation still the likeliest scenario, the Federal Reserve shouldn't consider cutting rates unless the economy slows rapidly, the International Monetary Fund said Wednesday.

Still, the tenor of the report suggests the IMF sees more balance between US economic growth and inflation risks, whereas the Fed has repeatedly said inflation as its "predominant" concern. "Current policy settings are consistent with a soft landing and core inflation of under 2%," the IMF said in its annual report on the US economy. "However, tight labor markets and other inflation risks justify caution in lowering interest rates unless activity weakens rapidly," the IMF said. IMF staff issued a preliminary report June 22 following consultation with US authorities, including Fed officials. The report released Wednesday is more comprehensive and was signed off by top IMF officials. The Fed has kept the federal funds rate at 5.25% since June 2006, a period encompassing eight Federal Open Market Committee meetings. The FOMC is widely expected to keep rates steady again when it meets next week and maintain its longstanding anti-inflation bias. IMF staff and Fed officials view the current Fed funds rate as "mildly restrictive," according to Wednesday's report, which has led to a softening in underlying inflation. The IMF economic forecast expects US gross domestic product to expand 2% this year and 2.75% in 2008, close to what the IMF considers the US's non-inflationary growth potential of "almost 3%." But there are risks, the IMF said. The US "is likely to remain for some time uncomfortably close to the 2% 'stall speed' associated with past recessions, even though indicators such as unemployment and real interest rates are more favorable," the staff report said. The US economy grew just 0.6% in the first quarter before rebounding to 3.4% growth in the second. Economists have generally looked at the first two quarters as an average, given temporary factors that boosted growth in the second quarter and weighed on it in the first. "The upside potential from net exports in a robust global environment is more than offset by downside concerns" from subprime mortgage problems that could hit housing and consumption, the IMF said. If subprime problems lead to a broader turn in credit markets, economic activity could also suffer given the use of collateralized loan obligations to fund leveraged buyouts, the IMF said. US officials "agreed that rising corporate indebtedness in recent leveraged buyouts and the easing of loan covenants were a concern, but emphasized the strength of corporate and financial sector balance sheets," according to the IMF report. In contrast to its view that upside risks are "more than offset" by downside ones when it comes to economic growth, the IMF seemed more upbeat on inflation, calling inflation risks only "slightly" to the upside.

Further Dollar Depreciation Seems Likely

Still, Fed officials "expressed concern over inflation," the IMF said. The IMF's consultations with the US central bank suggest Fed officials aren't close to resolving their internal debate over whether to set numeric inflation targets. The Fed has a dual mandate of stable inflation and maximum sustainable employment but, unlike other major central banks, doesn't have a specific inflation objective. Fed officials have long been assumed to have a comfort zone of 1% to 2% annual growth in its preferred inflation gauge, the personal consumption expenditures price index excluding food and energy, which is currently running at 1.9%. IMF staff "observed that quantifying the Fed's longer-term inflation objective might help further anchor expectations," according to the IMF report. Fed officials "responded that, while individual members may have expressed personal opinions, there was no collective FOMC view on the appropriate range for inflation," the IMF said. The IMF said further dollar depreciation seems likely given the roughly 15% depreciation since 2002 has had only a "limited" effect on the US trade deficit. "According to staff analysis by the Consultative Group on Exchange Rates (CGER), further real effective dollar depreciation of 10%-30% would be required to eliminate the misalignment relative to medium-term macroeconomic fundamentals," the IMF said. US officials countered that the CGER models "failed adequately to factor in nontrade fundamentals such as capital flows" and that "long-term real interest rate differentials continued to signal little market concern about large or disorderly dollar depreciation," according to the IMF report.