Federal Reserve Chairman Alan Greenspan yesterday issued a broad warning that the U.S. economy is growing so rapidly that inflation could easily get worse. If that appears likely, the central bank "will have to act promptly and forcefully" to keep prices in check, he told the House Banking Committee.
"Should productivity fail to continue to accelerate and demand growth persist or strengthen, the economy could overheat," Greenspan said in a semiannual monetary policy report. "That would engender inflationary pressures and put the sustainability of this unprecedented period of remarkable growth in jeopardy."
Many financial analysts had been expecting less-strident language from the chairman, particularly since most recent data have shown inflation remaining relatively low and some mild moderation in previously booming consumer spending. The analysts were divided over whether the Fed is likely to raise its target for overnight interest rates -- which it boosted to 5 percent from 4.75 percent at the end of June -- at its next policymaking session Aug. 24.
Greenspan's tone also surprised bond traders and investors, who pushed down bond prices after concluding the Fed was more likely to increase interest rates. Bond prices move in the opposite direction of yields, so the yield on 10-year U.S. Treasury notes -- which heavily influences interest rates on 30-year fixed-rate home mortgages -- climbed to 5.77 percent, from 5.65 percent at yesterday's market close.
"Greenspan struck a more hawkish note than the markets expected in his . . . testimony," said Bruce Steinberg, chief economist at Merrill Lynch & Co. in New York.
Stock prices, however, were barely affected, even though the Fed chairman reiterated warnings that stock prices may be unsustainably high.
Greenspan said a rapid increase in productivity -- the amount of goods and services produced for each hour worked -- has helped firms hold down costs and boost profits without raising prices. "The danger is that in these circumstances, an unwarranted, perhaps euphoric extension of recent developments can drive equity prices to levels that are unsupportable" and lead to an "inevitable adjustment," he said.
Steinberg noted that Greenspan stressed the Fed's need to evaluate new economic data as it ponders its next step. If new figures show no added evidence of overheating or rising inflation -- and Steinberg thinks they will not -- "the Fed will remain on hold at the next . . . meeting," he predicted.
In contrast, Ray Stone of Stone & McCarthy, a financial markets research firm in Princeton, N.J., said the tone of Greenspan's testimony suggested the chairman will be pushing for a second quarter-point rate increase next month.
Greenspan told Congress that technological advances and sharp increases in business investment in equipment have caused labor productivity growth to accelerate significantly in recent years. That has increased the pace at which the economy can expand without adding to inflationary pressures, but actual economic growth has nevertheless been running higher still, he said.
As a result, the nation's pool of job seekers has been shrinking rapidly and the unemployment rate -- 4.3 percent last month -- is close to a three-decade low. "One indication that inflation risks were rising would be a tendency for labor markets to tighten further," Greenspan said.
But the Fed chairman went one step further than he has before in discussing whether tight labor markets pose an inflationary threat.
Previously, he has suggested only that it wouldn't be good, in terms of inflation, if the jobless rate were to fall further. Yesterday, however, he also said Fed policymakers need "to assess whether the existing degrees of pressure in these markets is consistent with sustaining our low-inflation environment."
In effect, Greenspan was cautioning that the current low jobless rate might not be consistent with keeping inflation low. That situation could arise, he indicated, if productivity growth stopped accelerating -- that is, not slowing down, but no longer increasing at an ever faster pace.
Should that acceleration cease -- and Greenspan said that sooner or later it will -- any move toward larger wage gains would "put pressure on firms to raise the prices of the goods and services they sell."
Greenspan also clarified for analysts one lingering controversy concerning the Fed's recent rate hike. When the Fed raised rates at the end of June, the policymakers also announced they had adopted a neutral stance, indicating that they were equally likely to cut rates in the future as raise them. At least that is how market participants interpreted the announcement.
Not so, Greenspan said yesterday.
The policymaking group, the Federal Open Market Committee, "did not believe that its recent modest tightening would put the risks of inflation going forward completely into balance," he said. "However, given the many uncertainties surrounding developments on both the supply and demand side of the economy, the FOMC did not want to foster the impression that it was committed in short order to tighten further. Rather, it judged that it would need to evaluate the incoming data" for more signs of potential inflation problems.
CAPTION: Federal Reserve Chairman Alan Greenspan's strongly worded remarks to the House Banking Committee yesterday surprised many investors and analysts.