Greenspan warns on rising US budget deficit

The truce between Congress and the Federal Reserve over US fiscal policy ended abruptly yesterday as Alan Greenspan warned that mounting budget deficits would eventually trigger hikes in interest rates.

The Fed chairman told US lawmakers a return to "budgetary profligacy" would harm hopes of a long-term recovery for the American economy.

He also revealed that the Fed would slash its growth forecasts and warned the economy was still suffering the effects of terrorist attacks, stock market slumps and savage cuts in business spending.

"To date, the economy appears to have withstood this set of blows well, although the depressing effects still linger and continue to influence, in particular, the federal budget outlook," he said.

The gloomy outlook, combined with an unexpected spike in jobless benefit claims, knocked confidence on Wall Street where the Dow fell as much as 162 points in morning trade.

Economists said Mr Greenspan's brief comments on the economy gave few clues to the Fed's decision on 24 September when the markets expect no policy change. The main thrust of his testimony to the House of Representatives' budget committee was to urge lawmakers to keep a tight rein on spending.

"Given the recent change in the budget outlook, the commitment to fiscal responsibility that has served us so well must be re-established," he said.

He warned that a failure to renew tight laws on budget control would be a "grave mistake". "If we don't preserve the budget rules and reaffirm our commitment to fiscal responsibility, years of hard work could be squandered," he said.

The Congressional Budget Office predicts the deficit for the fiscal year to 30 September will hit $157bn (£101bn) after four straight years of surpluses, and stay in the red until 2005. Mr Greenspan told the cross-party committee: "An abandonment of fiscal discipline will eventually push up interest rates, crowd out capital spending, lower productivity growth, and force harder choices upon us in the future."

But in a major boost for the White House, Mr Greenspan focused his criticisms on spending policy rather than on the impact of the tax cuts ordered by President George Bush last year. He rejected suggestions by Democrats that some of the $1,350bn of tax cuts planned over the next decade should be rescinded.

"There is a significant segment of the business community who presumably made capital investment commitments ... expecting that the long-term tax structure will remain in place," he said. "If you rescinded it they would consider it a tax increase."

David Sloan, US economist at 4cast in New York, said: "Greenspan has said the tax cuts were the right thing to do but he does not want any more. If the White House pushed for more it could not rely on his support."

Meanwhile the European Central Bank kept its key rate unchanged at 3.25 per cent. Its president, Wim Duisenberg, said: "The risks to price stability appear rather balanced. Against this background, the current level of key ECB interest rates is appropriate."