“More than worries over war with Iraq are holding back the economic recovery, a top Federal Reserve policy maker said, raising the prospect another interest-rate cut may be needed even if the U.S. wins the war quickly,” writes Greg Ip in today’s Wall Street Journal.

” ‘Recovery in the business sector continues to be restrained not just by geopolitical uncertainty and the need for further restructuring in some key sectors, but by caution on the part of investors and lenders,’ ” Federal Reserve Bank of New York President William McDonough said in an speech to the New York State Bankers Association.”

“The big question is whether the economy’s anemic growth — underlined by Thursday’s reports of high jobless claims and falling leading indicators — is a result primarily of war-related jumpiness or something more deep-seated. Fed Chairman Alan Greenspan has emphasized the former, a view the Fed reiterated Tuesday when it left its short-term interest-rate target at 1.25% and blamed ‘oil price premiums and other aspects of geopolitical uncertainties’ for the “hesitant” expansion.”

“According to that view, the economy will rebound if the U.S. wins the war quickly, and the Fed won’t have to lower rates again. The rally in stocks and drop in oil prices that began last week and continued Thursday is supporting that optimistic script for now.”

“While Mr. McDonough didn’t address the immediate economic outlook or this week’s policy decision, his remarks indicate that some at the central bank worry that the economy won’t rebound once the war ends. At their late January policy meeting, some Fed officials warned ‘it was possible that some easing of geopolitical tensions would not lead to a major near-term upturn in business confidence and business expenditures,’ according to meeting minutes released Thursday.”

“Still, the Fed appears intent on awaiting the war’s outcome before deciding where the economy is headed and if rates must fall again. At their January meeting, according to the minutes, officials imagined scenarios requiring big moves in interest rates ‘in one direction or the other in the months ahead.’ “

“Mr. McDonough said investors and lenders are still worried about the reliability of corporate governance and accounting statements. Such concerns would make capital scarcer, deterring businesses from undertaking new projects.”

“More broadly, Mr. McDonough said, ‘The effects of the bursting of the stock-market bubble have proven to be far more long-term and pervasive than expected.’ Indeed, the bubble itself was ‘fertile soil’ for the same governance problems afflicting business investment, he said. Those problems continue to surface, as shown by accounting scandals at Dutch supermarket operator Ahold NV and HealthSouth Corp.”