Washington, July 21--Fed Chairman Alan Greenspan said today the U.S. central bank aims to continue raising interest rates at a gradual clip over the next 18 months or so, but is ready to "respond promptly and flexibly" if inflation proves to be higher than policy makers now expect.
Delivering a semi-annual report on monetary policy to Congress, Greenspan said the latest economic data show the U.S. economic recovery has become "broad-based" and "self-sustaining." He downplayed worries that the recovery is losing steam, saying the recent weakness in consumer spending is likely to prove "short-lived." Under the circumstances, he said, the Fed must raise its key federal-funds rate to a "more neutral setting" that neither stimulates nor curbs economic growth.
"Some risks necessarily attend this transition, but they are outweighed in our judgment by those that would be associated with maintaining the existing degree of monetary-policy accommodation in the current environment," Greenspan said in prepared remarks to the Senate Banking Committee. "As we attempt to assess and manage these risks, we need to be prepared for the unexpected and to respond promptly and flexibly as situations warrant."
The remarks suggested the central bank sees no reason either to interrupt or accelerate the campaign of interest-rate increases it began last month, when it lifted the funds rate by a quarter percentage point from a 46-year low of 1%.
Economic data since then have suggested both an upswing in inflation and a slowdown in economic growth. Wall Street commentators have been divided over the meaning of that data, with some predicting the Fed might pause its interest-rate campaign and others saying the central bank would step up the pace of rate increases.
Greenspan, however, said that the rise in inflation and the apparent slowdown in economic activity since the spring appear to be the result of temporary forces. The broadest measure of consumer-price inflation, he said, has "been elevated by the indirect effects of higher energy prices on business costs' and the effects of the dollar's depreciation last year. Higher energy prices, moreover, have also taken a temporary toll on consumer spending.
He added that employers have been hiring workers at a pace that should have "important follow-on effects for household spending." Over the last six months, he said, non-farm payrolls have grown at an average of 200,000 a month -- up from an average of 60,000 a month in the fourth quarter of 2003. "There have been much clearer indications over recent months that conditions in the labor market are improving," Greenspan said.
As Greenspan spoke, fed-funds futures sold off to factor in an almost 100% chance of a quarter percentage point increase in the benchmark rate at the Aug. 10 Federal Open Market meeting, an 85% chance of a 25 basis point rise at the Sept. 21 meeting and a fed-funds rate of 2% by the end of the year. Eurodollar futures, which offer a slightly longer-term look at expectations, factored in about a 3% funds rate by the middle of 2005.
Greenspan said financial markets are prepared for increases. "Prices in financial markets have already adjusted in anticipation of a significant amount of policy tightening, engendering additional alteration of balance sheets in recent months," he said.
Households, he said, are also "reasonably well prepared. In any case, he said, increases in the funds rate in the past haven't always generated big increases in mortgage rates. From early 1999 through early 2000, he said, "the average interest rate on the total of home mortgage debt outstanding barely moved" even though the fed-funds rate climbed by one and a half percentage points.
The Fed said the "central tendency" of forecasts prepared by members of the central bank's monetary-policy committee shows that the broadest measure of inflation is likely to show a gain of 1.75% to 2% in 2004, and more or less stay in that range through 2005.
The gross domestic product should grow between 4.5% and 4.75% in 2004, and settle to a range of 3.5% to 4% in 2005. The unemployment rate, now 5.6%, should fall as low as 5.25% by December and as low as 5% by the end of 2005, the policy makers said.
