Greenspan faces rough waters

[notiCIas]

Greenspan faces rough waters

Federal Reserve chief must walk a fine line between economic slide, inflationary overheating.

June 8, 2005: 3:29 PM EDT


WASHINGTON (Reuters) - Far from coasting into his place in history, Federal Reserve Chairman Alan Greenspan must spend the waning months of his tenure parsing unusual signs that have economists warning variously of a dangerous economic slide or a risk of an inflationary overheating.

As forecasts for the U.S. economy's path -- and Fed interest-rate policy -- diverge, experts keep up their warnings about potentially destabilizing economic imbalances.

Greenspan, due to step down in January after 18 years at the Fed's helm, will have a chance Thursday in congressional testimony to clear up confusion over how he will try to navigate safely through the shoals.

Financial markets will listen intently for clues as to whether investors' bets that the Fed will soon halt a year-long campaign of raising rates still look wise.

On the surface, the economy seems to be chugging ahead at a clip that is decent, if unspectacular. It grew at a 3.5 percent annual rate in the first quarter, just a touch slower than at the end of last year and about what economists say is sustainable over the long haul without much inflation.

While job growth tanked in May, Fed officials can take comfort in a longer trend that shows employment gains strong enough to slowly put the unemployed back to work.

But the expansion has been notably uneven -- housing is booming, while the manufacturing sector is unable to create jobs and may be softening.

"We're getting some quite mixed signals," said Martin Baily of the Institute for International Economics. He conceded that the uneven numbers weren't surprising in an economy settling into a mature expansion after a fast-growth recovery phase.

"You're starting your descent, so to speak, and that always gives people a lurch and a start," he said.

Most forecasters see steady growth ahead, but some warn of troubling chinks in the economy's armor. Forecasters at UCLA -- early predictors of the 2001 recession -- think another downturn could come next year.

Can you say conundrum?
Greenspan's testimony comes amid a 2-1/2 month-long rally in the bond market that last week took the yield on the 10-year Treasury note to 14-month lows below 4 percent.

The drop in long-term interest rates has come even as the Fed raised overnight lending rates to 3 percent in eight straight quarter-percentage point steps over the past year -- a puzzle even Greenspan admits has him scratching his head.

Market mavens are divided over whether the long-rate plunge portends economic weakness, as history would suggest, or marks excess economic stimulus that could spark inflation or further inflate what some see as a housing-market bubble -- that could take the economy down with it when it pops.

Greenspan said Monday the fall in long rates was "clearly without recent precedent" and due to "new forces" in the international marketplace. Then he raised, and largely dismissed, a series of potential explanations.

"It's really quite something when the chairman of the Fed says, 'Gee, I don't know what's happening to interest rates," Baily said. "At least he's honest about it."

Greenspan said the notion it flagged softer growth ahead was "credible," but also noted occasional signs of economic strength had failed to stem the global bond rally -- leaving both optimists and pessimists claiming he was in their camp.

"What the bond market is telling the Fed and investors alike is that deflation, not inflation, remains the primary longer-term economic risk," David Rosenberg, chief North American economist at Merrill Lynch, wrote Tuesday.

Rosenberg thinks the Fed, which next meets on June 29-30, will call it quits after two more quarter-point rate hikes that markets have already priced in.

Other economists are not so sure. In a Reuters poll of 22 major bond-trading firms Friday, the median forecast was for overnight rates to hit 4 percent by year end -- a full percentage point above their current level -- and some analysts see them moving even higher in 2006.

"The bond market is not understanding what the Fed is trying to communicate," former Fed governor Lyle Gramley said. He said Greenspan would likely be more blunt in Thursday's congressional testimony than he has been so far.

"Greenspan will leave no doubt, although he won't say it, that the Fed is going to continue to raise interest rates."