WASHINGTON -- Alan Greenspan, chairman of the Federal Reserve Board, warned Congress yesterday to stick with the Clinton administration's $500 billion deficit reduction target or risk the wrath of the financial markets.
The Fed chief also all but ruled out any reduction of short-term interest rates to offset the economic drag from the new taxes in the budget package now being worked out by a Senate-House conference committee. He signaled that the central bank stood ready to increase rates if necessary to combat inflation.
Mr. Greenspan rejected the idea floated by some lawmakers, notably Sen. John B. Breaux, D-La., that Congress should settle for a deficit reduction of $400 billion instead of the administration's original target of $500 billion because 1993 deficit projections have been revised downward.
The lower projection -- $285 billion instead of $319 billion -- has been seized on by some members of Congress as a path of retreat from some of the unpopular tax increases and spending cuts in the bill. But Mr. Greenspan warned that the financial markets were expecting "a credible initiative" to reduce the deficit.
Noting that even the $500 billion proposal would not prevent the deficit from rising again by the end of the century without health care reform, Mr. Greenspan said: "If the markets perceive that we are backing off the size of the commitment . . . I think that they will react appropriately negatively." The $500 billion program is "probably about the right size" for now, he said.
The central banker, delivering his annual report on monetary policy to Congress, was cautiously reassuring about short-term economic prospects but more bullish about the long-term outlook.
Provided the "major questions" over the federal budget and health care were resolved and existing restraints on growth waned, he said: "The U.S. economy should eventually emerge healthier and more vibrant than in decades."
Even as he spoke on Capitol Hill, the government released new evidence of sluggish activity -- a stalled new-home market. After rebounding from a winter slump in April and May, housing starts leveled off in June, as the lowest interest rates in 20 years -- averaging 7.16 percent for a 30-year mortgage -- failed to tempt more homebuyers into the market.
The stock and bond market reactions to Mr. Greenspan's remarks were muted, with dealers' prime interest focused on the deficit-reduction package.
The major emphasis of Mr. Greenspan's testimony was on the need to control inflation and keep long-term interest rates low, fostering economic activity. "On balance, the news on inflation this year must be characterized as disappointing," he said.
Despite consumer caution, a weak labor market, corporate downsizing and government cutbacks, inflation had "at best stabilized," Mr. Greenspan said. He put the likely average rate for the year at between 3 percent and 3.25 percent.
The effort to contain inflation, he said, was complicated by high inflationary expectations, which had "tilted upward," driving the price of gold up and causing bond yields to spike higher. Any "ill-timed easing" of rates could cause a further "flare-up" in expectation.
In May, the Federal Open Market Committee, which sets the central bank's policy, perceived a growing threat of inflation from increases in retail sales, capacity utilization, and consumer confidence, he said. It quickly adopted a bias toward raising interest rates.
But the economy lost its head of steam as defense spending dropped, exports dwindled, and the consumer shopping spree ended, persuading the Fed not to take any action.
The economic growth rate in the first quarter of the year was a meager 0.7 percent, but has since strengthened and is expected to finish the year at between 2.25 percent and 2.50 percent, a downward revision of the Fed's February prediction of a 1993 growth rate of between 3 percent and 3.25 percent.
The Fed's report yesterday projected unemployment would drop from the current 7 percent to 6.75 percent by the end of this year and to perhaps 6.5 percent next year.
Democratic members of Congress were hoping for some hint of lower rates from Mr. Greenspan yesterday to offset the drag new taxes are expected to put on an already weakened economy later this year as new taxes are levied.
Bond dealers were looking to the Fed's readiness to move promptly against any sign of a wage-price spiral.