Greenspan's Mixed Message


By Rich Miller Shades of irrational exuberance. In presenting what could be his final semi-annual economic report to Congress, Federal Reserve Chairman Alan Greenspan cautioned bond-market investors on July 20 that they may be taking too much risk with their money.

In driving down government and corporate bond yields around the world, investors are betting on an increasingly stable global economy and a trouble-free outlook, Greenspan said. The danger, he told lawmakers, is that "long periods of relative stability often engender unrealistic expectations...and, at times, may lead to financial excess and economic stress."

But just as they did in 1996, when Greenspan warned of a giddy stock market, investors quickly dismissed the Fed chief's words of caution. Bond prices did fall slightly in the wake of his testimony to the House Financial Services Committee, but later recovered to end the day little changed.

COMFORT ZONE. In many ways, Greenspan has no one but himself to blame for the markets' ho-hum reaction to his remarks. Even while he cautioned investors against complacency, he presented a benign forecast of solid economic growth and contained inflation over the next 18 months.

And though he ticked off a series of risks to the outlook, including sky-high oil prices and a frothy housing market, Greenspan then proceeded to downplay their significance. Perhaps more importantly, he said the Fed was managing monetary policy to prevent a spike in bond yields, giving investors an extra measure of comfort.

Although the yield on the Treasury's key 10-year note has risen over the last three weeks, it's still about a half percentage point lower than it was just over a year ago, before the Fed started raising short-term interest rates.

"SIGNS OF FROTH." The problem, from Greenspan's point of view, is that the low bond yields give added oomph to the economy at the same time that the Fed is trying to remove what it calls "monetary accommodation" from the financial system by raising short-term rates.

That's especially true in the housing market. Greenspan came as close as he ever has to declaring housing a bubble. "Whether home prices on average for the nation as a whole are overvalued...is difficult to ascertain, but there do appear to be, at a minimum, signs of froth in some local markets," he said.

Greenspan also admitted that he couldn't rule out a nationwide decline in house prices. But he maintained that the economy could weather the fall-out.

OIL'S LIMITED IMPACT? Banks are larger and more diverse than in the past, and thus better able to ride out any regional house-price busts. And even with the boom in mortgage borrowing of recent years, many homeowners still have substantial equity in their houses.

The Fed chief was similarly comforting about other risks facing the economy, which has withstood the sharp rise in oil prices without suffering a serious slowdown in growth or a significant rise in inflation.

If energy prices flatten out, the prospects for both growth and inflation look favorable, Greenspan said. He acknowledged that slowing productivity growth and rising labor costs could put upward pressure on inflation. But he said it was too soon to say for sure what the impact would be.

PREDICTABLE REACTION. It's clear that the Fed chief is preoccupied by the low level of bond yields. He devoted about a third of his 12-page prepared testimony to trying to explain what's going on. He attributed the low yields to a global excess of savings over investment, diminishing inflation expectations, and the apparent stepped-up risk-taking by bond-market investors.

But he failed to mention the Fed's own role in keeping yields down. Over the last year, Fed policy couldn't have been more predictable -- with the central bank raising short-term rates at a measured pace of a quarter percentage point each monetary meeting.

That steady policy path has encouraged bond investors to take on more risk without fear of being surprised by sudden changes from the Fed. Couple that with mostly soothing rhetoric from Greenspan about the economic outlook, and it's no wonder that bond investors appear worry-free.

DEAF EARS. The risk is that investors will snap out of their complacency at some point, sharply pushing up bond yields and undermining the economic expansion.

Greenspan tried to head off that possibility with his warning to the market on July 20. But so far at least, investors don't seem to be listening. Miller is a senior correspondent in BusinessWeek's Washington bureau


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