Federal Reserve Chairman Paul Volcker warned yesterday that large projected federal deficits threaten "prolonged strain and congestion in financial markets" that could keep interest rates high and choke off economic growth this year.
Testifying to the Joint Economic Committee, Volcker several times urged Congress and the administration to take action this year to reduce the federal deficits for 1983 and later years.
About $100 billion of actions to close the deficit were needed for fiscal 1984 he said, with correspondingly smaller amounts in 1983. However, President Reagan later said in his State of the Union address to Congress that he would not ask for a major increase in taxes to narrow the 1983 and 1984 deficits and confirmed that the deficit will be "too high" in the next three years.
Some experts believe that there will not be sufficient overall spending cuts, after the defense build-up, to bring the deficits in those years below $100 billion. Volcker commented that deficits of this size, assuming that the economy is recovering, "would seem to me to be too big."
Volcker pointed out that even if money growth is kept within its targets this year, there is room for faster M1 growth than there was last year. Economists testifying before the JEC last week said money policy was too tight, and should be eased, and fiscal policy for later years tightened.
With the reduction in inflation last year, there was a real chance of bringing a permanent improvement in inflation, Volcker said. "Price expectations have calmed, and there is some evidence that the underlying trend of costs is slowing" he said.
But despite this, long-term interest rates remain exceptionally high. Volcker said that this suggested investors now fear inflation may worsen in the future. Easing of money policy would not help to reduce rates but might even push them up, he said, by exacerbating this fear. Volcker also told the committee that "paradoxical as it may seem" action to narrow the federal deficit through a combination of lower spending and higher taxes "can be a major element, through its implications for credit markets, in promoting reecovery and nurturing it."
But without new action to cut spending or raise taxes, the paths of spending and revenues are divergent, he said, meaning that if there is no new budget action the federal deficit will get larger and larger in coming years.