Double Whammy

By Adam Zagorin/Washington

^ The Federal Reserve Board is normally the Stealth bomber of government agencies, zooming in without warning to raise or lower interest rates, and confirming weeks later what action was taken. But last Friday, in an extraordinary pre-emptive strike against a possible surge of inflation, Federal Reserve Chairman Alan Greenspan declared that the central bank had raised short-term rates that very day. Although Greenspan had warned earlier in the week that an increase was likely, the news sent shock waves through Wall Street. The Dow Jones industrial average plunged 96.24 points to close Friday at 3871.42 for the sharpest sell-off since Nov. 15, 1991.

While some panicky traders took the rate hike as a signal that the bull market might be over, other Wall Street watchers shrugged off such fears. "The market overreacted," asserted Edward Yardeni, chief economist for the investment firm C.J. Lawrence. "It's better for the Fed to tighten a little bit now rather than a lot later." Yet worried traders and investors remained shaken. Said Stan Weinstein, a stock market analyst and newsletter publisher in Hollywood, Florida: "The market is going to be awfully nervous next week."

The Federal Reserve action highlighted the growing strength of the U.S. economy as Bill Clinton prepared to unveil a new budget filled with painful spending cuts this week. Greenspan's announcement came after the Commerce Department reported that sales of new homes climbed 11.4% in December to the highest level in seven years. Factories have also been humming: Commerce said new orders rose for the fifth straight month in December, and a survey of private purchasing managers found that the advances continued in January. While the unemployment rate rose to 6.7% in January from 6.4% in December, that reflected a change in the method of calculating the rate. Under the old method, joblessness would have fallen to 6.3% last month.

The resurgent recovery has increased tax revenues and helped the Administration reduce the federal budget deficit to a surprising extent. Just one year ago, the Congressional Budget Office projected a whopping $284 billion shortfall for fiscal 1995, which begins next October, and $287 billion for fiscal 1996. But last month the nonpartisan CBO predicted the budget gap would narrow to $166 billion in 1996. That would trim the deficit to just 2.2% of the country's gross domestic product, the lowest level since 1979. "Clinton's tax increases and spending cuts are largely responsible," says CBO director Robert Reischauer. "We have taken an important step along the road to fiscal responsibility."

Clinton's new budget is even tougher than last year's. To comply with spending caps enacted in 1990 and reinforced last August, Clinton aims to slash outlays for nine of 14 federal departments, ranging from Education to Agriculture. That will distribute tens of billions of dollars in budget cuts over some 300 government programs. More than 100 others would be eliminated outright, stretching from a Commerce Department undersea research project to a program aimed at helping keep students from dropping out of school.

At the Pentagon, which absorbs roughly one out of every five federal dollars, the leadership of all three services has braced for draconian cuts. Only a week before Defense Secretary Les Aspin was fired in December, officials confirmed that current funding would fall $50 billion short of supporting the force levels Clinton has called for through 1999. Indeed, Clinton's budget slashes $1.4 billion in defense procurement programs, almost half the overall $3.25 billion in cuts the President is recommending. But the proposals will encounter strenuous opposition from congressional Republicans and such leading Democrats as Sam Nunn of Georgia, who chairs the Senate Armed Services Committee.

Reductions in cherished social programs will be just as tough for many Clintonites to swallow. As Cabinet Secretaries have trooped into the Oval Office to meet with the President in recent weeks, each has faced major disappointments. To raise extra cash to finance AIDS research, childhood immunizations, Head Start and increased job training, Clinton plans to reduce funding for everything from public housing to mass transit to assistance for the poor to help heat their homes. All told, the budget calls for 118,000 fewer civilian workers on the federal payroll by Sept. 30, 1995, than when Clinton took office.

Many legislators want the cuts to go deeper still. The Senate is poised to take a fresh look at a hardy perennial when it debates a balanced-budget amendment later this month. While a comparable measure was defeated in 1986, this one has gained public support around the country and could stand a better chance. Meanwhile, deficit hawks led by Democratic Senator Bob Kerrey of Nebraska plan to propose more than $100 billion in spending cuts next month. A similar package failed in the House last year by only six votes.

Any long-term attack on the deficit must include a healthy economy that can keep profits and incomes rising and a strong stream of revenues flowing into government coffers. In moving to raise interest rates last week, the Federal Reserve wagered in effect that an increase now would prevent the economy from overheating and maintain inflation at its current modest level of about 3%. That combination of sustainable growth and stable prices could be a deficit buster's best friend.

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CREDIT: TIME Chart by Peter C.T. Elsworth

CAPTION: Roping It In