Key aides to President-elect Bill Clinton are considering an unusual strategy to attack the budget deficit, in which the Federal Reserve Board would reduce interest rates while the White House pursues a program of spending cuts and tax increases.
Such an approach--requiring extraordinary cooperation from the independent Fed--would be designed to salvage economic growth, despite the array of anti-deficit measures that otherwise could jeopardize a modest recovery.
“The Federal Reserve has been making veiled hints for years that it might cooperate in such a venture,” said a knowledgeable source in the Clinton camp. “The Bush Administration never took them up on it.”
The focus on a possible role for the Federal Reserve comes as Clinton’s inner circle is heatedly debating economic policy priorities in the final hours before taking the reins of government. Increasingly, expensive campaign spending promises are coming up against severe pressure on Clinton to combat a widening deficit, projected to exceed $300 billion this year.
A drop in rates could clearly help Clinton stem the red ink without torpedoing the economy in the process, according to two private analyses recently conducted for Laura D’Andrea Tyson, who will run the White House Council of Economic Advisers.
For example, a decline in short-term interest rates--of between half a percentage point and a full point--would help keep the U.S. economy chugging forward while enabling Clinton to achieve his deficit-reduction goals through spending cuts and tax hikes, concluded the WEFA Group and DRI-McGraw Hill, private economic forecasting firms that conducted computer simulations for the Clinton team.
The President-elect has said he wishes to shrink the spending gap by $145 billion annually by the end of his term and lately has de-emphasized his separate goal of stimulating the economy through extra spending.
Interest rates are the principal tool available to jog the economy if Clinton chooses to avoid a deficit-widening spending stimulus or tax cuts.
The one-two combination of deficit reduction and lower interest rates would require coordination--or a tacit understanding--between the Clinton White House and Federal Reserve, an independent body that sets interest rate policies. The chances of that are unclear. Indeed, some of Clinton’s lieutenants fear the Fed is on a course of stable or rising interest rates in light of recent signs that the recovery has strengthened.
Fed Chairman Alan Greenspan met with Clinton for more than an hour in early December and is rumored to be receptive to helping him attack the deficit. However, key policy decisions at the Fed are made by a 12-member committee, whose willingness to play ball in a cooperative anti-deficit strategy is not known.
The Fed’s more fundamental mission is to guard against inflation, which it typically does by raising interest rates as an economic recovery picks up momentum, not by lowering them to accommodate politicians in the executive branch or Congress.
Most analysts see little danger of inflation in the short run, however. While U.S. economic growth moved up into the 3% range in the last half of 1992, consumer prices rose just 2.9% over the last 12 months, the most tepid increase in six years. Few foresee a sharp upturn in the economy next year.
“Probably if we were going to cut the deficit in half by 1996, the Fed would be on board and willing to massage interest rates down a notch,” maintains Robert F. Wescott, a senior vice president at WEFA, a Philadelphia-area firm that submitted a package of dozens of budget tables now circulating among Clinton insiders.
Earlier this month, Tyson asked the consultants to calculate the effects of a wide range of deficit-cutting options. Each firm responded with a similar menu of choices that reflect the limited options available to the Clinton Administration. These included higher taxes on gasoline, alcohol, cigarettes and incomes of the wealthy, along with cuts in defense spending and caps on health care programs.
The measures, reminiscent of Ross Perot’s anti-deficit crusade, highlight the mixed rewards of waging an all-out effort to chop the deficit. Such an array of benefit cuts and tax hikes is deemed essential to restoring financial health to the U.S. government for the long haul. In the short run, however, they jeopardize economic growth by reducing the spending power of millions of Americans.
That is the predicament that prompted Clinton’s advisers to consider how monetary policy, which is the domain of the Fed, could offset the damage of a more austere fiscal policy.
Bush Administration officials pressured the Fed to speed up interest rate cuts in 1991 and 1992, but the traditionally aloof central bank resisted, causing a chill between officials in the White House and the Fed. Yet if the pace of interest rate cuts did little to rescue the slumping economy during Bush’s Administration, some analysts believe the outcome now might be more positive.
“The way to do this right is to engineer a fiscal contraction with a monetary expansion so you don’t kill off the economy while you’re reducing the deficit,” said the Clinton aide who declined to be identified.
Advisers to Clinton turned to the private economic firms earlier this month for a range of computer calculations. DRI-McGraw Hill, of Lexington, Mass., found that if short-term rates were engineered three-fourths of a percentage point downward, Clinton and Congress could chop $50 billion a year off the deficit without killing off a recovery.
Long-term interest rates, such as for home mortgages, are determined by financial markets, rather than the Federal Reserve. They too would be expected to fall if the budget deficit shrank dramatically.
Clinton aides last week disclosed they are considering a package of tax increases and spending cuts that would drastically shift federal budget priorities by the mid-1990s. The disclosure came after final forecasts by the Bush Administration that the budget gap will balloon in the future--by $68 billion more in 1997 than previously predicted.
In light of the changing picture, a furious debate is raging around Clinton over economic policy priorities, Roger Altman, Clinton’s pick for deputy Treasury secretary, conceded in Senate testimony last week.
Still, some of Clinton’s advisers would like to salvage at least part of their spending initiatives, such as for the nation’s infrastructure.
“Let’s be blunt about it--you’ve got to work hard to cut the budget deficit in half by 1996,” Wescott said, referring to one of Clinton’s campaign pledges.