Greenspan Skips Short-Term Deficit Risk to Rates: John M. Berry
March 2 (Bloomberg) -- Federal Reserve Chairman Alan Greenspan said last week that big federal budget deficits eventually would lead to increases in long-term interest rates large enough to undermine U.S. economic growth.
However, Greenspan skipped over the possibility that ``eventually'' could arrive as soon as next year, leaving Fed policy makers with a potentially serious problem on their hands.
Perhaps the chairman didn't want to spook the markets. Perhaps he didn't want to go nose-to-nose with President George W. Bush over tax cuts, though Greenspan himself wants taxes to be as low as possible.
``The particular point where I think we have to be very careful is that point in which the expectation of looming deficits in the next decade begin to impact on long-term interest rates currently,'' Greenspan told the House Budget Committee.
``I don't know where that is. I don't believe it's in the immediate future. It's out there in this decade by all of the analysis that we can make,'' he said.
The reason the budget outlook could impact rates as early as 2005 isn't that this year's deficit is likely to be around half a trillion dollars.
Rather, it's because Bush, concentrating on re-election and making permanent virtually all the tax cuts enacted in the past three years, has presented no realistic plan for curbing future deficits.
Neither has his likely Democratic opponent, Senator John Kerry of Massachusetts.
Sharp Rise Possible
Right now, long-term U.S. rates are being anchored by several factors, including the Fed's 1 percent target for overnight rates, a very tame outlook for inflation, and an insatiable appetite at several Asian central banks for U.S. Treasury securities.
When the economy and the labor market strengthen enough that the Fed begins to raise that target, long-term rates are going to rise, perhaps sharply.
That could trouble Fed officials who at that point may want to move slowly -- rather than preemptively -- in raising rates at a time inflation is still well in hand.
Peter Hooper, chief U.S. economist at Deutsche Bank Securities in New York, told clients last week that Asian purchases of Treasuries ``will not stand in the way of the bond market carnage that will accompany the initial Fed move.''
If investors looking ahead see the prospect of the Treasury and private borrowers competing for funds, the increase in long rates will be magnified. Foreign investors' appetite for holding dollar-denominated assets could be affected as well, putting new pressure on the dollar and rates.
Greenspan Ignored Risk
Obviously no one can be sure how the market will respond under such circumstances. However, the risk is there, and the risk-averse Fed chairman chose to ignore it.
One thing Greenspan, who routinely stresses the uncertainties of budget projections, could have done last week would have been to recommend holding off on any decision about whether to make the Bush tax cuts permanent. After all, the only cut expiring at the end of the year is the 50 percent bonus depreciation on business equipment purchases, and Bush doesn't want that provision extended.
Whether the cuts stay on the books makes an enormous difference in the long-term budget outlook. And politically it would be much harder to raise the taxes again than to let some of them expire on schedule, which is why Bush is pushing so hard to have them made permanent.
In response to questions from committee members, Greenspan said, as he did last year, that the cuts should be made permanent only if offsetting spending cuts or tax increases were part of the deal.
Budget Projections
Bush likes such restrictions only on spending increases, not tax cuts. So Greenspan was disagreeing with the president.
However, what came across much more loudly than the caveat was the chairman's agreement on making the tax cuts permanent.
Greenspan made things worse with some inexplicable comments about the need for continuous tax cuts to offset income tax bracket creep. The brackets have been indexed for inflation since the early 1980s, and if rising real incomes are pushing taxpayers into higher brackets, that's a wholly different matter.
The unrealistic nature of Bush's latest budget projections was spelled out by a number of analysts late last week, including some at Goldman, Sachs & Co. and HSBC Securities USA Inc. as well as Deutsche Bank.
Skeptical Eye
In New York, Ian Morris, chief U.S. economist at HSBC, looked at the Bush budget and Kerry's campaign proposals and concluded that ``deficits of $400-450 billion are likely until 2008 and beyond under both men. This would raise the public debt to GDP ratio from 37 percent to 45 percent in 2008.
``Unfortunately, higher than expected growth is not likely to bail the deficit out the way it did in the 1990s,'' Morris said. ``Meanwhile, history suggests that Congress will not get serious about deficit cutting until a fiscal shock or crisis occurs.''
At Goldman Sachs in New York, senior U.S. economist Ed McKelvey cast a skeptical eye at the latest projections from the Congressional Budget Office, which showed a cumulative $1.9 trillion deficit for the years 2005-2014 and a miniscule $13 billion surplus in the final year.
McKelvey disagreed strongly.
``Merely keeping defense (spending) at its current 4 percent of GDP, a low level historically, adds $1 trillion (plus interest) to the 10-year deficit,'' McKelvey said. ``Making the personal tax cuts permanent adds another $1.4 trillion (plus interest).''
Indexing the alternative minimum tax, which has to happen sooner or later, allowing non-defense discretionary spending to grow 2 percent a year in real terms and adding an extra $600 billion for the additional interest bill would bring the cumulative deficit for those years to $5.5 trillion, according to his analysis.
Spigot Problem
Meanwhile, one of Hooper's colleagues at Deutsche Bank, senior economist M. Cary Leahey, went through a similar exercise with similar results.
``Temporary deficits are not a problem,'' because short-term stimulus can help a weak economy, Leahey said. ``But turning off the spigot after 'priming the pump' has proved difficult in the past.''
``Conventional analysis suggests that the deficits gradually erode long-term growth. They do so by eventually crowding out private investment, which is competing with the government for scarce capital,'' he said.
Clearly there's no such competition at the moment, and there might not be next year either.
However, savvy investors already know how hard politically it will be to turn off that fiscal pump. And if after the election there is no realistic plan for shutting it off, long- term interest rates could end up rising a good deal faster than Fed policy makers may wish.
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