Federal Reserve Chairman Alan Greenspan warned Friday that recent gains in U.S. home prices, stock values and other forms of wealth may be temporary and could easily erode if long-term interest rates rise.
Households and businesses have been able to spend more by transforming houses, stock and other assets into cash, he noted. But Americans should not assume that such good times will roll on forever.
"What they perceive as newly abundant [cash] can readily disappear," Greenspan said.
His words followed statements the Fed chief has made in recent months that housing prices in some markets have risen to unsustainable levels and that individuals are taking on increasingly risky mortgages. But Greenspan's comments Friday represent a broader warning, with the Fed chief indicating he believes much of the run-up in housing and stock prices over the past decade has been due to low long-term interest rates, which could rise if global financial conditions shift.
"History has not dealt kindly" with those who underestimate such risks, Greenspan said in remarks delivered at the opening of an economic conference here focused on his 18 years as Fed chief.
Stock prices fell in trading Friday after Greenspan suggested that the value of such assets may be headed lower in the future. Financial markets have responded to Greenspan's warnings in the past, only to shrug them off subsequently. In 1996, he famously warned that "irrational exuberance" might be pumping up stock prices; stocks fell briefly only to climb almost continuously for the following three years.
At the conference's opening session Friday, Greenspan was lauded by current and former colleagues and other analysts for his performance and wisdom as Fed chief. "When the score is toted up, we think he has a legitimate claim to being the greatest central banker who ever lived," wrote former Fed vice chairman Alan S. Blinder and Ricardo Reis, both Princeton University economists, in a paper presented Friday.
The Fed has been raising its benchmark short-term rate for more than a year and has signaled that it probably will keep lifting it in the months to come to keep the lid on inflation. But the Federal Reserve does not set long-term rates, such as those that determine mortgage rates and corporate borrowing costs. Those are affected by international financial markets in response to many factors.
Long-term interest rates remain very low, in part because inflation has remained tame outside of energy costs. Overseas investors have been pouring money into U.S. stocks and bonds, helping dampen long-term rates. But Greenspan said low long-term rates also reflect investors' belief that the U.S. economy is so healthy that there is little risk in lending money here.
Thus, lenders set rates lower because they demand a lower "risk premium," Greenspan said.
"This vast increase in the market value of [stocks, bonds, houses and other assets] is in part the indirect result of investors accepting lower compensation for risk," Greenspan said. "Such an increase in market value is too often viewed by [investors] as structural and permanent."
But we live in an ever-changing economy and an uncertain world, the Fed chief emphasized. Investors could easily get spooked, become more cautious, boost interest rates, and thereby deflate the values of homes and financial assets, he said.
Greenspan said earlier this year that investors are not necessarily irrational in expecting economic waters to stay calm. In Greenspan's nearly two decades at the Fed, other speakers Friday noted, inflation has fallen very low and the economy has enjoyed its longest peacetime expansion with just two mild recessions. This experience contrasted dramatically with the turmoil of the 1970s and 1980s, when inflation and interest rates soared and the nation experienced the deepest downturns since the Great Depression.
Speaking explicitly about the economy, but also implicitly about his tenure as Fed chairman, Greenspan said that since 1987 the nation has survived two sharp stock market declines and the Sept. 11, 2001, terrorist attacks. He also said the economy has so far managed "to weather reasonably well the steep rise" in energy prices over the past two years.
Greenspan acknowledged that Fed policy has been "an important contributor to the decline in inflation and inflation expectations" over that period. But he credited the Fed under his predecessor Paul A. Volcker for doing "the very heavy lifting against inflation." Volcker, who served as Fed chairman from 1979 to 1987, pushed interest rates to double-digit levels to break inflation and start driving it downward, contributing to a severe recession in the early 1980s.
In addition, Greenspan said one of the Fed's major accomplishments in recent years was its willingness "to recognize that the U.S. and global economies were evolving in profound ways" and to tailor the central bank's inflation-fighting strategies accordingly.
But Greenspan attributed the economy's resilience primarily to increased "flexibility" -- his term for the freedom of U.S. financial markets to respond to sudden events through changes in prices, interest rates and exchange rates. That contrasts with the U.S. price controls and heavier regulation of many industries in the early 1970s and with other governments' restrictions on their own markets and industries today.
"To some extent, those higher [house, stock and other asset] values may be reflecting the increased flexibility and resilience of our economy," he said.
These qualities also mean that the nation's housing boom and outsized trade deficit need not be solved through deep downturns in economic growth or employment, he said. "The more flexible an economy, the greater its ability to self-correct in response to inevitable, often unanticipated disturbances."