Greenspan warns Congress on twin deficits

Alan Greenspan, the Federal Reserve chairman, painted a rosy short-term picture for the US economy yesterday, but warned that soaring and untackled budget and trade deficits could sooner or later push up interest rates and upset currency markets.

Barely a fortnight after jolting markets with a hint that interest rates might rise, Mr Greenspan yesterday reassuringly asserted that continuing low inflation would permit the central bank to be "patient" before pushing up short-term rates from their current near 45-year low of 1 per cent.

That in turn should assist the economy to continue to grow robustly, and help unemployment to edge downwards for the rest of the year. This is despite what the Fed chairman described as "stunning" gains in productivity that kept companies from taking on new workers.

As managers became more confident the current expansion would continue, "firms will surely once again add to their payrolls", Mr Greenspan said, in words which will cheer President George Bush as he gears up for a tough re-election campaign in which Democrats are bound to point to the 2.3m jobs lost since he took office in 2001.

For 2004, the Fed expects the US economy to expand by up to 5 per cent, a quarter point higher than the central bank was predicting just six months ago, and a pace significantly stronger than anything likely in Europe or Japan.

The headline unemployment rate is forecast to drop slightly from its current 5.6 per cent by the end of the year, while inflation is likely to hold at between 1 and 1.25 per cent - a level representing what the central bank reckons to be price stability.

But as he presented the Fed's monetary report to Congress yesterday, Mr Greenspan gave one of his sternest warnings yet about the budget deficit, which even the White House forecasts at a record $521bn for this year.

He also raised the alarming prospect of foreigners losing their willingness to finance America's current account deficit - now $500bn or almost 5 per cent of GDP.

He told the House Financial Services Committee: "Given the already substantial accumulation of dollar-denominated debt, foreign investors, both private and official, may become less willing to absorb ever growing claims on US residents."

In that event, the central bank could be forced to raise interest rates more quickly than it would like, which in turn would probably send stock prices tumbling, slow the current recovery and worsen the employment outlook.

That statement contrasts starkly with the Bush administration's contention that the deficits are under control and pose no danger to current interest rate levels.

In his habitual, somewhat tortuous style, Mr Greenspan challenged Congress to take action. Deficit reduction, he said, should be achieved by cuts in spending, rather than by raising taxes.

Either way, he said, if investors were to become "significantly more doubtful that Congress will take the necessary fiscal measures, an appreciable back-up in long-term interest rates is possible".

Mr Greenspan listed other risks which could ambush the US economy in the year ahead, including a sudden increase in oil prices imposed by producers alarmed by the steady decline in the value of the dollar, or a surge in protectionism.