New Greenspan Warning Throws Scare Into Market

Federal Reserve Board Chairman Alan Greenspan said Wednesday that the U.S. economy has been on “an unsustainable track” and has not slowed enough to eliminate the threat of renewed inflation.

His statement, delivered in testimony before Congress, sounded a warning bell to the nation’s financial markets to temper the kind of speculation that has sent stock prices soaring recently.

Although Greenspan has cautioned against such speculation before, analysts said he is worried that the markets have not heeded his message and may be heading for a “bubble” that could burst and hurt the economy.

Although analysts were divided over whether Greenspan’s remarks pointed to an increase in interest rates before the end of the year, Wall Street was quick to react.

The Dow Jones industrial average plunged 117 points in a frenzy of trading, recovering by the end of the day to close at 8,095.06, down 83.25 points--about 1%--from Tuesday’s close. Prices of long-term bonds also plunged.

Analysts said it appeared that Greenspan has been worried that the markets have taken the Federal Reserve’s last such action--a decision on Sept. 30 to leave interest rates untouched--as a green light to push prices ever higher.

Both the stock market and the bond markets have surged since the Fed passed up a chance to raise rates then, with investors apparently convinced that there has been virtually no risk of an increase soon.

Federal Reserve policy-makers have been warning for months that they would be prepared to raise interest rates further if the economy does not slow from its first-quarter pace, but so far they have hesitated to do so.

Although the economy has continued to grow rapidly, inflation appears to have receded slightly in recent months, making it difficult for the central bank to cite it as a villain.

New statistics published Sept. 26 showed that the economy grew at a 3.3% annual rate during the second quarter of this year--below the first quarter’s 4.9% pace, but not as big a slowdown as some policy-makers had hoped.

While some analysts expect the economy to slow further during the second half of this year, Greenspan’s message Wednesday was that the nation’s central bank is prepared to act if the growth rate does not ease on its own.

Analysts were split over whether the chairman’s statement signaled a likely tightening of money and credit policies later this year, at its two regularly scheduled meetings on Nov. 12 and in mid-December.

David M. Jones, analyst for Aubrey G. Lanston & Co., a Wall Street investment firm, said the odds that the Fed would tighten sometime this year “have bounced back to above 50%”--from a very slim chance before.

But Robert G. Dederick, economist for Northern Trust Co. in Chicago, said everything depended on the circumstances in place when policy-makers meet to consider their next moves.

“If circumstances remain what they are now--with low inflation and more moderate growth--then I don’t know why the Fed would tighten at all,” Dederick said. “There’s no reason for them to do that.”

Greenspan also urged lawmakers to keep the federal budget in surplus once it is balanced in 2002 rather than spending any excess revenues, as some members of both parties have proposed.

He said the budget-balancing accord reached by the White House and Congress earlier this year should be regarded as only a “down payment” on steps needed to bring the budget into line.

Greenspan also appeared to try to end speculation that he had joined those who believe that the economy can grow more rapidly than previously thought because technology has made it more productive.

According to that view, the increased productivity has overturned an earlier rule of thumb that the economy could not grow faster than 2.5% a year without bringing on labor shortages that would threaten to rekindle inflation.

While Greenspan had given some encouragement to the faster-growth advocates before, he asserted on Wednesday that it “strains credibility” to contend that labor shortages do not bring on more inflation.

He also said bluntly that while the economy slowed somewhat in the second quarter, “it did not slow enough” to eliminate the danger that current labor shortages might send wages soaring and reignite inflation.

“The performance of the labor markets this year suggests that the economy has been on an unsustainable track,” he said.

As recently as last July, Greenspan had appeared to be less concerned about the possibility that the economy was overheating, but in a speech at Stanford University in September, he warned again that the Federal Reserve was on alert.

On Wednesday, Greenspan once again implied that he thought stock prices were overvalued, arguing that it would be “unrealistic” to expect the stock market to continue rising at its current pace.

Richard B. Berner, chief economist at the Mellon Bank in Pittsburgh, said it was “very clear that [Greenspan] wanted to go out of his way to correct the notion” that he believed the economy could continue to grow unchecked.

“The irony,” Berner said, “is that the inflation risks have probably lessened somewhat in recent weeks.”