Federal Reserve Chairman Alan Greenspan said yesterday that the central bank will raise interest rates as aggressively as necessary to keep inflation under control.
Greenspan said Fed officials continue to believe they can raise rates at a "measured" pace because of their economic forecasts. But he acknowledged that they might be wrong and have to shift their strategy, which would mean raising rates more quickly or in larger steps than previously envisioned.
"Should our judgment prove misplaced . . . [the Fed] is prepared to do what is required to fulfill our obligations to achieve the maintenance of price stability," the chairman said, according to the text of a speech he delivered via satellite to a conference in London.
Although inflation remains very low by most measures, it has jumped in recent months by a degree that has surprised many at the Fed. Bond prices fell following Greenspan's speech, as many investors concluded that either inflation or interest rates may rise faster this year than they have expected.
Greenspan and other Fed policymakers have signaled repeatedly that they will start raising their benchmark short-term rate from its very low 1 percent level when they meet later this month and will continue to raise it for some time after that. Analysts and investors generally anticipate a quarter-percentage-point increase at that meeting but have been divided over the likely pace and size of increases to follow.
Fed officials said after their last meeting in early May that they believed they probably could raise rates at a "measured" pace. Many analysts have interpreted a "measured" pace to mean quarter-point increases spread over many months or even a few years, gradually raising the benchmark rate, called the Fed funds rate -- the rate charged between banks for overnight loans -- to a level that neither stimulates nor puts the brakes on economic growth.
After Greenspan's speech, " 'measured' is not guaranteed," said Ian C. Shepherdson, chief U.S. economist for High Frequency Economics Ltd., in a note to clients. The chairman is "clearly not yet ready to make the case for [half-point] moves, but this could be the first step."
Greenspan's remarks were the latest of many by Fed officials that have appeared aimed at guiding financial market expectations about the central bank's intentions, to help investors adjust gradually to the higher interest rates that will come with a stronger economy. Fed policymakers also want to tamp down any potentially self-fulfilling expectations that inflation might take off because the central bank is too complacent.
"The commitment of the Federal Reserve to maintaining price stability remains strong and unaltered," Donald L. Kohn, a Fed governor, declared in a speech Friday.
The path of raising rates to do so, he said, "will depend critically on the behavior of inflation."
Both Greenspan and Kohn prominently noted the recent rise in inflation and sounded more concerned about its likely path than in other recent comments.
Consumer prices, excluding those in the volatile food and energy categories, rose 1.4 percent in the 12 months ended in May, according to a Commerce Department gauge favored by the Fed. That is a low "core" inflation rate and well within the comfort range of many Fed officials. But it has risen steadily since December, when it was 0.8 percent.
This rise surprised Fed officials who had predicted early this year that inflation would stay very low and possibly even decline further because of slack in the economy -- relatively high unemployment and unused production capacity.
Kohn outlined several one-time or temporary factors that help explain the jump in inflation, including higher prices for raw materials, the weakness of the dollar and the rebound of inflation from an abnormally low level a year ago.
Kohn said he still believes "the rise in inflation will be limited," but made plain his heightened wariness by adding, "Experience counsels caution. There is much about the inflation process that we do not understand, and I have been surprised at the extent of the pickup in core inflation."
Greenspan noted recent developments that have removed some of the restraints on inflation that had caused it to fall last year. For example, businesses' labor costs per unit of output have started to rise this year, after falling last year.
And, he said, "the persistence of the rise in energy prices is a worrisome element in the cost picture."
The stakes are high for the Fed in managing this policy transition.
Fed officials want to avoid a repeat of the financial turmoil that occurred in 1994 and 1995, when the central bank surprised many investors by lifting its overnight rate to 6 percent from 3 percent in just 12 months. The Fed's actions contributed to the Mexican peso crisis, the failure of investment bank Kidder Peabody & Co. and the Orange County, Calif., bankruptcy, according to many analysts.
So this time around, Greenspan and others have painstakingly warned that rates are headed upward and indicated that they will move slowly if they can. Already many long-term interest rates set by financial markets -- such as mortgage rates -- have been rising in anticipation.
But the Fed's plans can change, Greenspan cautioned yesterday. "Economic developments going forward will determine the level and term structure of interest rates."