updated 7/21/2004 12:28:59 PM ET 2004-07-21T16:28:59

Federal Reserve Chairman Alan Greenspan said Wednesday that President Bush’s three rounds of tax cuts prevented a severe recession and helped spark the current economic recovery.

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But he warned that Congress must pay attention to the long-term consequences of its spending and tax decisions in order to keep rising budget deficits from harming the country’s growth potential.

Greenspan said that “what we are missing is a process, a long-term outlook” of the impact of spending and tax decisions on the budget.

“We need a mechanism which adjusts programs as we move forward,” Greenspan said.

Greenspan renewed his call for Congress to put back in place a budget mechanism that requires any new spending increases or tax cuts to be offset by spending reductions in other government programs or tax increases in other areas.

The Bush administration has supported such pay-as-you go procedures for government spending but not tax cuts.

Greenspan, however, refused to criticize Bush’s original $1.3 trillion in income tax reductions approved in 2001 or the subsequent two rounds of further reductions for businesses and individuals, saying that tax relief had helped to make the recent recession mild and brief.

Democrats contend that the tax cuts caused the federal deficit to balloon to record levels and went primarily to wealthy tax payers.

“I am for lower taxes and lower spending and lower deficits,” Greenspan told the House Financial Services Committee in his second day of testimony on the Fed’s midyear economic outlook.

Greenspan, appearing before the Senate Banking Committee on Tuesday, said if inflation should suddenly worsen, Fed policy-makers would abandon their current strategy of gradually raising interest rates and take more aggressive action.

He said that part of the recent increase in inflation has been due to temporary factors, such as a spike in energy prices.

Still, higher prices for energy and other goods has contributed to a recent slowdown in consumer spending, which accounts for roughly two-thirds of all economic activity, he said.

“The little bulge in inflationary pressures seems to have created a soft patch here,” Greenspan said. “And, it is something, obviously, we are watching very closely.”

Recent economic data, including retail sales, the nation’s payroll situation, industrial production and housing construction, suggested the economy hit a rough patch in June. Sen. Jim Bunning, R-Ky., worried that June’s economic “hiccup” could “turn into the flu.”

But Greenspan expressed confidence that June was just a temporary lull rather than a sign of trouble ahead for the economy.

“While there has been weakness in June, ... I might say that July seems to be somewhat better, even though we are going through a soft patch,” Greenspan told the Senate panel. He noted that auto sales, which were sluggish in June, are rebounding now that discounts and other incentives have been expanded again.

“There is no real underlying evidence of any cumulative weakness here,” Greenspan said of the national economy.

Economic conditions through the first half of the year have “been generally quite favorable,” with overall growth at a strong rate that has finally generated a significant rebound in job growth, Greenspan said.

If inflation remains under control, the Fed can hold to its current view that it can raise interest rates gradually. But if inflation should show signs of worsening, then the Fed would need to accelerate its rate increases, Greenspan said.

The Fed boosted interest rates June 30, the first time in four years, acting to keep inflation at bay. It raised a key rate to 1.25 percent from a 46-year low of 1 percent.

Private economists continue to believe the Fed will boost interest rates by another one-quarter percentage point at its next meeting on Aug. 10.

The Fed had cut interest rates 13 times starting in January 2001 and ending in June 2003. The credit-easing campaign was aimed at helping the economy rebound from the collapse in tech stock prices in 2000, a recession, the 2001 terror attacks and a series of corporate accounting scandals.

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