Belt-Tightening Time Inside the Beltway

But will Congress cooperate in an election year?

In 2001, Washington policymakers spent much of their time shoveling money out the door. In a failed attempt to stave off recession, Federal Reserve Chairman Alan Greenspan slashed interest rates to their lowest levels in four decades. President Bush rammed a $1.3 trillion tax cut through Congress in the summer, then blessed $40 billion in emergency government spending following the September 11 terrorist attacks. The putatively laissez-faire Bush also backed a $15 billion bailout for the airlines and paved the way for import protection for steelmakers.

Now, with the economy widely expected to pick up in the first half of 2002, policymakers face the less palatable task of tightening their belts. At the Fed, that means deciding how much, if any, of 2001's cuts to take back. For Bush and congressional leaders, it means making tough choices about where to cut government spending to rein in reemergent budget deficits.

In the bond market, there's little doubt that the Fed will respond promptly and aggressively to any signs of recovery. Futures markets are pricing in 1 1/2 percentage points or more of Fed tightening in 2002, starting in the second quarter. But Fed officials--even inflation hawks--believe market expectations of rapid-fire rate hikes are overblown. For one thing, they're not as convinced of an early, V-shaped recovery as the markets are. Moreover, they are not overly worried about a pickup in inflation, even if the recovery arrives earlier and turns out to be stronger than they expect. In fact, with unemployment rising and factories operating at just 75% of capacity, Greenspan & Co. are looking for inflation to fall, not rise, in 2002.

Of course, the money mavens don't rule out rate hikes: A modest rise in short-term rates toward the end of 2002 seems like a good bet. After all, some of the cuts since September 11 were undoubtedly intended to guard against a complete collapse of the economy after those attacks. As the recovery becomes more firmly ensconced later in the year, look for the Fed to gently nudge rates back up about three-quarters of a percentage point.

On the fiscal front, White House Budget Director Mitch Daniels has already told Congress that budget surpluses could be history if lawmakers don't rein in federal spending. While the White House is willing to give a free pass to defense and homeland security, it will red-pencil other requests for stepped-up expenditures.

Budget experts, however, say Daniels' tough talk may not amount to much. Sure, the Administration is likely to propose a tightfisted budget in February--officials predict the Bush budget will boost nonwar spending by just 2% to 3%. But there's little chance that lawmakers will agree to such tough curbs on spending in a congressional election year.

More action is likely on the regulatory front. In the wake of Enron Corp.'s collapse, Securities & Exchange Commission Chairman Harvey L. Pitt is expected to put forward new rules on financial disclosure so that investors have a clearer idea of what companies are up to. He'll also give the audit committees of corporate boards more responsibility in overseeing what their accountants and auditors are doing. Restrictions are likely on companies stuffing employee 401(k) plans with the company's own stock, as Enron did.

All in all, it looks like a busy year. Not as frenetic as 2001, but lively enough to keep investors on their toes.

By Rich Miller

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