The US Federal Reserve is intent on defusing mounting imbalances between supply and demand and will support higher borrowing costs to prevent the booming economy from overheating, Fed Chairman Alan Greenspan said on Thursday.
Sending a clear signal a rise in short-term interest rates is imminent, Greenspan told the Economic Club of New York the Fed did not have the luxury to wait until the forces shaping the fast-changing US economy come into clearer focus.
Blaming a "huge" rise in equity prices for increasing consumer wealth and driving aggregate demand to a point where supply could not keep pace without fanning higher inflation, Greenspan said rising interest rates were the only way to restore balance in the world's biggest economy.
"In the end, balance is achieved through higher borrowing rates," he said, adding that a recent rise in market interest rates was "supported by a central bank intent on defusing the imbalances that would undermine the expansion."
Wall Street economists in the audience took Greenspan's words as a gentle but clear sign the Fed remains on a path toward tighter credit and would notch up the 5.5 percent fed funds overnight bank lending rate by a quarter point at its next policy meeting on 1-2 February.
But they were not left with the impression a more aggressive move was coming.
"I didn't get the sense of urgency in terms of more aggressive Fed action sooner. I certainly didn't get the feeling that 50 basis points of tightening in February was any more likely," said Michelle Gerard, Treasury market strategist at Prudential Securities.
"But clearly the Fed is in a tightening mode and is going to be inclined to raise interest rates until demand slows."
Greenspan said there was no evidence of inflation pressures yet despite labor market conditions tighter than any point in the past generation.
But he warned such signs of rising imbalances could bring the "economic expansion, its euphoria, and wealth creation to a debilitating halt."
"What he did say was that demand growth is simply too strong relative to growth of output to be sustainable without producing imbalances and strains and therefore the Fed will keep acting until the slowdown in spending growth," said John Lipsky, chief economist at Chase Manhattan Bank in New York.
"The Fed really doesn't have a clear view of how much it's going to take. It sounds like a Fed that will keep raising interest rates until it sees a clear sign of slowing spending growth."
If the Federal Open Market Committee (FOMC) does raise rates in early February, it would be its fourth increase in seven months aimed at keeping inflation at bay.
Lipsky predicted the bond market would take Greenspan's speech in stride, seeing it as a balanced assessment of the economy.
The yield on the inflation-sensitive 30-year US Treasury bond has risen to 6.65 percent from 6.21 percent a month ago as dealers priced in expectations the fed funds rate will rise by at least half a percentage point by mid-year.
Asian markets were the first to react to the Greenspan comments, which came at mid-morning Friday in East Asia.
Most share markets lost their stride on the higher interest rate signals, erasing gains registered before the speech began, but not falling sharply. Tokyo's key Nikkei index was virtually flat in afternoon trade, and currencies moved only marginally.
Some economists have speculated Fed policymakers are so concerned about the risk of overheating that they may decide to raise the fed funds by half a percentage point right away. But the Fed has not taken a half-percentage point step in five years, preferring instead to make incremental moves.
Greenspan also said that after last year's three rate increases, the process of rising credit costs was "already well advanced," suggesting he may be content with a quarter-point step for now. Fed policymakers meet again on March 21, at which point they could administer further tightening moves.
Wayne Angell, chief economist at Bear Stearns and a former Fed official, concluded from the speech that the Fed would raise rates by a quarter percentage point at both the February and March meetings.
The US economy is about to enter an unprecedented ninth year of expansion with growth averaging about four percent a year over the past several years. Unemployment is at its lowest point in some 30 years as US producers strain to satisfy red-hot consumer demand.
"There has to be a limit to how far the pool of available labor can be drawn down without pressing wage levels beyond productivity" and causing inflation to rise, Greenspan said.
"Admittedly, we are groping to infer where those limits may be. But that there are limits cannot be open to question."
Greenspan said productivity gains sparked most of all by advances in information technology had raised long-term profit expectations and "engendered a huge gain in equity prices."
"Through the so-called 'wealth effect', these gains have tended to foster increases in aggregate demand beyond the increases in supply," Greenspan said.
That demand could only be filled through rising imports, higher immigration rates, or falling unemployment, he added.
"The bottom line, however, is that, while immigration and imports can significantly cushion the consequences of the wealth effect and its draining of the pool of unemployed workers for awhile, there are limits," Greenspan said.
Gerard of Prudential Securities said Greenspan put a greater emphasis in this speech than he had in the past on the links between the wealth effect and excess demand in the economy, probably to support the case for higher rates.
Greenspan, who earlier this month was reappointed by President Bill Clinton Fed chief for a fourth term, said recent budget surpluses had helped to absorb "a good part of the excess of potential private demand over potential supply."
He urged the administration not to abandon fiscal discipline that could "obviate at least part" of the need for higher interest rates to keep the economy on an even keel.
Answering questions after his speech, Greenspan said the Fed would soon announce a new way of communicating its so-called bias, or inclination toward future rate changes.
