Greenspan Signals a Rate Increase Ahead

Federal Reserve Chairman Alan Greenspan bluntly declared Thursday that the nation’s economy is growing too fast for its own good and signaled that the central bank is about to raise interest rates in an attempt to slow it.

In addition, Greenspan questioned whether the sky-high stock market has become an “unstable bubble” and said the Fed has to be prepared to ride to the rescue if the bubble pops.

“While this stellar . . . economic expansion still appears remarkably stress-free on the surface, there are developing imbalances that give us pause and raise the question: Do these imbalances place our economic expansion at risk?” the Fed chairman told the congressional Joint Economic Committee.

On Wall Street, stocks rose and bond yields fell despite Greenspan’s apparent rate warning, with the Dow industrials adding 56.68 points to 10,841.63.

Stocks would normally drop on news of higher interest rates, which slow the economy by discouraging borrowing by businesses and consumers. But analysts said that the markets’ rally was not as perverse as it might at first appear. Greenspan himself emphasized that any steps the Fed takes are likely to be “modest preemptive actions” rather than a sustained squeezing of the economy.

Besides, they said, the week’s other big economic news--that consumer prices did not rise at all last month--suggested that fears of inflation being on the move again were overblown, so the central bank need not take heroic measures.

Greenspan’s remarks all but guarantee that the Fed will nudge its key short-term interest rate, the federal funds rate, up a quarter-point from its current 4.75% when its policymaking body meets June 29 and 30. However, analysts were sharply divided over what will come after that.

“There’s a good chance the Fed is only going to raise a quarter-point, and that will be it,” said Bruce Steinberg, chief economist with Merrill Lynch & Co in New York.

“If the economy doesn’t slow and the stock market doesn’t stop rising, they will tighten again,” countered Mark M. Zandi, chief economist with Dismal Sciences Inc. in West Chester, Pa.

Investors and economists have been expecting the Fed to raise interest rates since the central bank’s policymaking body announced last month that it was leaning in favor of a rate hike.

Investors had built the assumption of at least a small hike into the prices of stocks and bonds before Thursday, which at least partially explains the oddly sunny reaction of financial markets to Greenspan’s warnings.

Investor nervousness about inflation went through the roof last month, when the government announced that consumer prices had jumped 0.7% in April. But such worries seemed to evaporate Wednesday, when Washington said that prices didn’t rise at all in May.

However the Fed chief appeared ready to push for modest increases as a “preemptive” strike against inflation. “When we can be preemptive, we should be,” he told lawmakers, “because modest preemptive actions can obviate the need of more drastic action.”

Greenspan offered an unusually clear picture of how he views the economy’s current performance.

Of the remarkable 4% growth in economic output in each of the last three years, he said 2 percentage points were due to technology-driven improvements in productivity, or output per worker. Another 1 point was traceable to the natural increase in the work force because of population growth and the remaining 1 point was the result of putting a larger-than-usual proportion of Americans to work, thereby driving the unemployment rate to a generational low.

The Fed chairman zeroed in on that last percentage point, calling it “unsustainable” and saying that it is being fueled by a disturbing trend, a stock market-fueled leap in consumer spending.

Although Greenspan stopped short of labeling the run-up in stock prices a bubble, he went further than ever before in casting doubt on whether the market can remain at such lofty levels.

He warned that long periods of economic growth, such as the current one, can breed optimism that lifts stock prices to “unsustainable levels even if product prices are relatively stable.”

“Whether that means an unstable bubble has developed . . . is difficult to assess,” he admitted.

Then he added, “A large number of analysts have judged the level of equity prices to be excessive.” And perhaps most telling, he suggested that the nation could weather a stock market tumble.

“While bubbles that burst are scarcely benign, the consequences need not be catastrophic for the economy,” he said.

Analysts said Greenspan’s remarks about stocks were decidedly tougher than when he criticized the market’s run-up in 1996. At the time, he suggested that the heights reached by the stock market were the product of “irrational exuberance.” Since then, the Dow Jones industrial average has nearly doubled.