Fed Chief Downplays ‘Stagflation’ Risk but Warns of Danger in Budget Deficits

Federal Reserve Chairman Alan Greenspan tried Thursday to allay fears that the economy faces a one-two punch of surging inflation and stagnant growth, although he warned that record federal budget deficits remain a serious long-term threat.

Economic “activity appears to be expanding at a reasonably good pace,” Greenspan told the Senate Budget Committee. His comments came amid rising concerns about economic growth, and just one day after a jump in consumer prices sent the stock market to new lows for the year.

The Fed chairman downplayed the prospect for “stagflation”-- an economic malady in which inflation rises despite sluggish growth. Asked whether the economy was entering a period of stagflation, Greenspan told the Senate panel: “It certainly doesn’t seem that way.”

Greenspan’s comments appeared to help reassure investors, who sent stock prices surging higher Thursday.

In addition, Greenspan urged China to stop pegging its currency to the dollar, a practice blamed for a widening U.S. trade deficit with China.

Citing a long-term concern, the Fed chairman repeated warnings about the danger of U.S. budget deficits, a problem that he said would require significant actions by Congress to fix. The federal budget is on “an unsustainable path,” he testified. “Unless that trend is reversed, at some point these deficits would cause the economy to stagnate or worse.”

In his testimony, Greenspan did not address the Federal Reserve’s next moves in interest rate policy. On March 22, the Fed raised its benchmark short-term interest rate by a quarter percentage point. The central bank is expected to raise interest rates again May 3.

Greenspan’s Capitol Hill appearance came at a time of growing anxiety over the economy.

During the first three months of the year, consumer prices -- pushed by a surge in energy costs -- have risen at a 4.3% pace, the highest since 1990. Prices at the gas pump have become a growing burden for households. Inflation fears have set the Fed on a path of steadily hiking interest rates.

But signs of slower economic growth could put the central bank in a policy bind, highlighting the downside of higher interest rates.

The weaker stock market, ballooning trade deficit and hints of slower growth in jobs and retail sales have reduced confidence in the outlook for growth.

Nonetheless, the economy has continued to grow, with many analysts still forecasting expansion of 3% to 4% for this year. According to the Fed’s latest “beige book” economic survey, business activity expanded throughout the country from late February to early April.

Greenspan on Thursday contrasted what he saw as the healthy near-term picture with a less-certain future, due in part to continuing budget deficits.

To finance the red ink, the government must borrow great amounts of money, which many economists say puts upward pressure on market interest rates. Higher rates, in turn, reduce the ability of businesses and ordinary consumers to spend and invest, trends that undermine economic growth.

“The positive short-term economic outlook is playing out against a backdrop of concern about the prospects for the federal budget, especially over the longer run,” Greenspan said, urging Congress to impose spending rules that would “signal a renewed commitment to fiscal restraint and help restore discipline to the annual budgeting process.”

The Bush administration projects that the federal deficit will reach a record $427 billion in the current fiscal year, which ends Sept. 30. The Congressional Budget Office has forecast a $394-billion deficit. The budget gap was $412 billion last year.

Greenspan on Thursday also emphasized the role that enormous healthcare expenses may play in the troubled fiscal outlook, warning that the possibility of new treatments could greatly increase future spending.

“The uncertainty about future medical spending is daunting,” he said.

To meet even currently projected spending, Congress would have to raise Medicare taxes, cut benefits or both, he said. “I do not see how we can avoid significant curtailment of benefits currently promised,” Greenspan said. “At the end of the day, we are going to end up with many people who are going to have very large co-payments and probably should.”

Separately, Greenspan urged China to overhaul its currency, which is pegged to the dollar and not allowed to float freely on foreign-exchange markets.

The Fed chairman said that China “should be moving sooner rather than later” to stop linking its yuan to the dollar, a relationship that Chinese officials have been reluctant to sever. American manufacturers have complained that China’s currency policy keeps its products at an artificially low price, aggravating this country’s trade deficit.

U.S. officials, including President Bush, have called on China to let the currency float.

Greenspan said Thursday that China would help control its own inflation by allowing the currency to rise in value, and he predicted that a policy shift was coming.

“I have no way of projecting when they will move,” he said, adding: “That they will move, I’m reasonably certain.”