Greenspan pledges low rates to ensure US recovery

Alan Greenspan, the Federal Reserve chairman, yesterday predicted that the US economy could move into an extended recovery in the second half of the year ­ and declared the Fed would keep rates low, and even cut them if necessary, to ensure this happened and to prevent a slide into deflation.

As Mr Greenspan spoke, the White House forecast the federal budget deficit would hit a record $455bn (£286bn) this year and $475bn in fiscal 2004, with large shortfalls continuing until at least the end of the decade ­ when the economy will have to confront the cost of the first retiring babyboomers.

Such deficits could be managed, if it was certain the budget would return to balance reasonably quickly, the Fed chairman warned the House Financial Services committee. But the US would face "major problems in the future unless we turn it around."

This is not the first time Mr Greenspan has expressed his concern about the latest massive tax cuts pushed through by Mr Bush, which some economists say could cost $800bn. Yesterday however, in his twice yearly monetary report to Congress, the Fed chairman said that tax cuts would have to be balanced by spending cuts if future budgets were to be brought under control.

As usual, Mr Greenspan's testimony was a carefully calibrated mixture of optimism about the future of the economy, and veiled warnings that the risk of deflation, entailing a downward spiral of prices, economic growth and jobs had not entirely disappeared.

Such a risk was "remote." But the central bank's rate-setting Federal Open Market Committee "stands prepared to maintain a highly accommodative stance of policy for as long as needed to promote satisfactory economic performance," he said, adding that scope even remained for a further cut in rates to ensure this happened.

The remarks were taken by some traders as a signal that after cutting the target fed funds rate by 25 basis points last month to a 45-year low of 1 per cent, the FOMC could reduce them again when it next meets on 12 August.

But the prospect did little to cheer markets. After an initial advance, the Dow Jones index ended down 48 points, while bond prices fell as Mr Greenspan appeared to rule out any extraordinary measures to pump money into the economy, such as buying up longer-term Treasury bonds.

In his prepared testimony, he said the FOMC at its June meeting had examined such "alternatives," but had agreed that it was unlikely they would be required. Instead Mr Greenspan tried to dispel the notion that rates were close to their floor, given the need to leave money market funds sufficient margin to cover expenses and still pay investors a return. Even though the target funds rate was only 1 per cent, "substantial further easings" were possible if the Fed considered them necessary.

But, he emphasised, the US economy "could very well be embarking on a period of extended growth," above the rate of productivity growth. This meant that employers would be taking on workers, causing the jobless rate to fall from its current nine-year high.

Answering questions after his testimony, Mr Greenspan also lent indirect support to calls for China to revalue its currency, which has been pegged at 8.277 to the US dollar since 1995. The slump in the dollar against the euro and yen over the past year has seen China's trade surplus soar and left the country with massive foreign currency reserves of $437bn.

As a result, Japan and Europe as well as the US have called for a revaluation of the yuan, with economists estimating the currency could be undervalued by up to 15 per cent.

Mr Greenspan said: "If [the yuan is undervalued], the accumulation of dollar assets will expand their money supply to a point which will create problems in managing monetary policy and it will be to their interest to change."

The Chinese central bank indicated earlier this week that it is considering ways to relax the link, although it ruled out any immediate change.