IMF Urges U.S. to Temper Fiscal Cuts

The International Monetary Fund took direct aim at sequestration Friday, saying in a report that the mandated across-the-board budget cuts are creating a drag on U.S. economic growth.

The U.S. economy is expected to grow by a tepid 1.9% this year, down from 2.2% in 2012, “owing to an excessively rapid pace of fiscal deficit reduction,” according to the IMF’s annual report on the U.S.

The IMF advises repealing the sequester and “adopting a more balanced and gradual pace of fiscal consolidation in the short term.”

U.S. growth would be far stronger if not for the mandated cuts, IMF economists said.

The sequester went into effect in March after Congress and the White House failed to agree on a compromise plan to cut government spending and reduce the U.S. deficit.

“The modest growth rate of 2.2 percent in 2012 reflected legacy effects from the financial crisis, fiscal deficit reduction, a weak external environment, and temporary effects of extreme weather-related events,” the IMF said.

Growth should pick up to 2.7% in 2014, however, as the U.S. economy rebounds. The IMF cited improving housing prices, an expanding construction sector, stronger household balance sheets, a gradually stabilizing labor market and robust corporate profits as indicators that the U.S. economy would fare better next year.

While the unemployment rate will likely hold at around 7.5% throughout 2013, the IMF predicted employment growth will accelerate late this year and in 2014, helped by an rise in output growth.

The IMF said the Federal Reserve board “appropriately” maintained its easy money policies, adding to its quantitative easing program last fall, in an effort to keep interest rates low and spur economic growth.

But the IMF was bluntly critical of sequestration.

“On the fiscal front, the deficit reduction in 2013 has been excessively rapid and ill-designed. In particular, the automatic spending cuts (“sequester”) not only exert a heavy toll on growth in the short term, but the indiscriminate reductions in education, science, and infrastructure spending could also reduce medium-term potential growth,” the report said.

The IMF recommended replacing the sequester with a mix of long-range cuts to costly entitlement programs such as Medicare and Social Securities and new taxes to raise revenues.

In addition, the IMF warned that a failure by Congress to raise the debt limit later this year could have severe long-term implications on U.S. borrowing costs. The fund also urged U.S. policy makers to continue working on a long-term plan to reduce U.S. debt.

Lack of such progress could have “severe repercussions for the U.S. and the global economy,” the report said.

The IMF noted the double-edged sword nature of the Fed’s $85 billion a month bond buying program. On the one hand, extending the program indefinitely could lead to asset bubbles in markets outside of U.S. Treasuries as investors search for higher returns.

However, “markets could over-react to initial steps by the Fed to normalize monetary policy conditions, leading to a sharp increase in long-term interest rates and financial market volatility, which if protracted would weigh on the recovery and have negative international spillovers.”

Stock markets have gyrated in recent weeks as investors have speculated over when and how the Fed will scale back its bond buying program.

Fed Chairman Ben Bernanke set off the speculation by commenting last month that the central back could consider tightening fiscal policy over the next few months.