Fed Fires a Warning Shot on the Deficit

In a warning shot aimed at Congress and the Clinton Administration, Federal Reserve Board Chairman Alan Greenspan signaled Tuesday that the central bank is likely to raise interest rates to head off rising inflation--or to counteract possible congressional backsliding on deficit reduction.

Greenspan cautioned that any attempt by lawmakers to back off their target of $500 billion in deficit reduction over five years would be a “negative” that would quickly roil the nation’s financial markets, prompting an increase in long-term interest rates. The Fed, he suggested, would then have little choice but to raise short-term rates to dampen inflationary expectations.

Faced with increasingly difficult budgetary choices, House and Senate negotiators who are trying to craft a compromise economic program tentatively have raised the possibility of scaling back the deficit-reduction target.

The Administration has strongly opposed such a move. But some in Congress have argued that it may be the only way to resolve the deep divisions between liberal Democrats in the House and conservative Democrats in the Senate over the most controversial tax and spending provisions in the budget package.

The Senate, for example, scrapped the Administration’s broad-based energy tax, replacing it with a modest 4.3-cent-per-gallon gasoline tax that would raise far less money. To make up the difference, the Senate took a bigger bite out of Medicare and scaled back several popular measures that were included in the House version of the budget, such as the creation of inner-city “empowerment zones.”

Greenspan, appearing Tuesday before a House subcommittee to review the health of the nation’s economy, declined to endorse Clinton’s economic program or any Republican-backed alternatives. Yet he insisted that the $500-billion deficit reduction target must be met for the final product to be taken seriously.

“I think it is important that some major credible deficit reduction bill be passed. . . . I fear that (without it), the markets would respond in a negative fashion,” Greenspan said.

A package that lowered the five-year deficit reduction target from $500 billion to $400 billion, for example, would lack credibility, he said.

If the financial markets should become convinced that Clinton and Congress will not achieve meaningful deficit reduction, they are likely to force long-term interest rates higher as insurance against future inflation.

“If the markets perceive that we are backing off the size of the commitment, I think that they will react appropriately negatively, because it is suggesting that the will of the Congress and the Administration to carry forward, to finally bring this process to success requires something large,” Greenspan said.

The Federal Reserve, meanwhile, released a semi-annual policy report revealing that the central bank has moved to tighten its long-range targets for monetary growth. It described the move as a “technical adjustment” that will not increase the likelihood of a quick jump in interest rates.

Greenspan, however, revealed that his agency came close to raising short-term interest rates at a key policy meeting in May. Continued weakness in job growth and the overall economy staved off any action, he said.

Beginning in late 1990, the Fed reduced short-term interest rates by a total of four percentage points in an effort to revive the stagnant economy by encouraging more borrowing and spending by businesses and consumers. The Fed has not changed interest rates since last September.

Greenspan said that the central bank is currently leaning toward higher--rather than lower--interest rates, despite it’s own forecasts that predict only modest economic growth for the remainder of the year. That policy, adopted at a May meeting of the Fed’s Open Market Committee, means that “further signs of (inflation) would merit serious consideration of whether short-term rates needed to be raised slightly,” Greenspan declared.

That is bad news for the Clinton Administration, which is trying to sell its budget package to Congress and the public by arguing that it will bring about a sustained reduction in interest rates.