Fed chair warns budget deficits could imperil economy's future

WASHINGTON -- Federal Reserve chairman Alan Greenspan warned on Wednesday that mushrooming federal budget deficits eventually could threaten the national economy, which he said had shown "impressive gains."

Greenspan, delivering the central bank's twice-a-year economic report card to Congress, offered a fairly upbeat assessment and expressed hope companies would step up hiring. Hiring has been painfully slow and become a political sore spot for President Bush.

Against that backdrop, Greenspan reaffirmed the Fed's stance that it would be patient in considering possible increases in short-term interest rates, which now are at a 45-year low of 1 percent. The comment pleased Wall Street. The Dow Jones industrials jumped 123.85 points to close at 10,737.70 -- the highest level in more than 2 1/2 years.

Still, he said low interest rates "will not be compatible indefinitely" with the Fed's primary job of fighting inflation. Some private economists believe the Fed could start nudging up rates this year. Others predict rates will not change until 2005.

Greenspan tempered his optimism with a dose of caution about the dangers of budget deficits.

Last week, the Bush administration projected that this year's deficit will reach a record $521 billion.

"Federal budget deficits could cause difficulties even in the relatively near term," Greenspan told the House Financial Services Committee.

"Should investors become significantly more doubtful that the Congress will take the necessary fiscal measures, an appreciable backup in long-term interest rates is possible," Greenspan said.

That view is at odds with the administration, which has argued that the deficits pose no immediate threat of pushing interest rates higher.

The administration has pledged to cut the deficit in half over the next five years. Rep. Jay Inslee, D-Wash., said that pledge was a "fantasy."

The committee chairman, Rep. Michael Oxley, R-Ohio, said the deficits are unavoidable given the challenges the country is facing.

"The alternative would be to stop investing in economic stimulus or to fight against terror on the cheap, and I don't think the American people would want either of those options," Oxley said.

Greenspan renewed his support for Congress to reinstate budget rules, which expired in 2002, that set caps on discretionary spending and required Congress to offset any new tax cuts or spending increases so the deficit would not increase.

He said that unless the government gets its financial house in order, the situation will grow more dire with the impending retirement of 77 million baby boomers.

"Without corrective action, this development will put substantial pressure on our ability in coming years to provide even minimal government services while maintaining entitlement benefits at their current level without debilitating increases in tax rates," he said.

Greenspan said the economic picture has brightened since summer. The economy grew at an average rate of 6.1 percent in the second half of 2003, the fastest back-to-back quarterly increases since the first two quarters of 1984.

"Overall, the economy has made impressive gains in output and real incomes; however progress in creating jobs has been limited," he told the committee.

Greenspan held out hopes for an improvement as businesses unable to squeeze more out of existing workers will begin hiring to meet increased demand.

"As managers become more confident in the durability of the expansion, firms will surely once again add to their payrolls," Greenspan said.

Committee Democrats pushed Greenspan to explain why 2.2 million jobs have been lost since Bush took office in January 2001, even with three successive tax cuts that the administration claimed would boost job growth. The Fed chief also was asked about the administration's forecast that 2.6 million jobs would be created this year.

For Americans out of work, it does not feel like an economic recovery. "The economy continues to perform extraordinarily poorly for people without jobs," said Rep. Carolyn Maloney, D-N.Y.

Greenspan said forecasts about job creation have been wrong in recent years because companies have been able to produce more with fewer workers. But he said productivity is likely to slow this year, triggering a rebound in job growth. He called the administration's prediction on jobs "a credible forecast" if productivity growth does slow down.

The Fed's economic forecast predicted that the unemployment rate, which dropped in January to 5.6 percent, would improve slightly, edging down to somewhere between 5.25 percent and 5.5 percent by the fourth quarter.

The Fed forecast that the overall economy will grow by between 4.5 percent and 5 percent in 2004 -- better than its forecast in July and up from a 4.3 percent increase for all of 2003.