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More Guarded Optimism from Greenspan

By Michael Wallace In the first leg of his semi-annual monetary policy testimony, delivered before the House Committee on Financial Services on Feb. 27, Federal Reserve Chairman Alan Greenspan detailed a U.S. economy in transition following the events of September 11. While he was optimistic that the economy was close to a turning point, he remained guarded about the pace and strength of the expected recovery.

The message for the markets: The Fed will likely refrain from tightening for an extended period and may not be that aggressive in taking back the unprecedented 11 rate cuts it delivered in 2001.

What the Fed chief said in his prepared remarks -- and during the question-and-answer session that followed -- was more or less an expansion of themes touched on by Fed officials in recent policy statements and speeches. "Forces that have been restraining the economy over the past year are starting to diminish, and activity is beginning to firm," Greenspan concluded. He also said the federal funds rate -- the key short-term rate that the Fed controls -- was at "a very low level," as adjusted for inflation. Taken together, those two factors explain the Fed's decision to leave rates unchanged at its January policy meeting -- and its retention of a bias toward further easing.

WELCOME NEWS. This proved of some comfort to Wall Street, as it indicated that the Fed chief is not in a rush to raise rates. And although data continue to suggest the economy is recovering, Greenspan's remarks on monetary policy mostly echoed the statement that accompanied the January meeting of the Federal Open Market Committee, the central bank's policy-setting arm.

Investors were relieved to hear this again. The Dow Jones industrial average ended the day higher, although the tech-laden Nasdaq struggled. The Treasury market rallied, pleased by Greenspan's remarks and the 14.8% drop in new-home sales in January, which satisfied any concern that the recovery might be gaining too much momentum.

The rest of the testimony dealt with a range of intriguing issues, from Enron to the negative-wealth effect. The Fed chief labeled Enronitis a short-term phenomenon that doesn't pose a significant risk to the financial system. Greenspan said over the long haul, "market discipline" would strengthen corporate governance, accounting standards, and investor confidence. He marveled at the strength in recent housing and consumption reports (the January new-home sales report notwithstanding) but hinted that these resilient sectors may not have much more to give.

DIMINISHED EXPECTATIONS. Greenspan warned "that the impetus to growth of activity will be short-lived unless sustained increases in final demand kick in before the positive effects of the swing from inventory liquidation dissipate." Ultimately, he said, "the broad contours of the present cycle have been, and will continue to be, driven by the evolution of corporate profits and capital investment."

His cautiously optimistic tone on the economy was underscored by the Fed's own underlying economic assumptions for 2002. These reflected a slightly more moderate outlook for economic growth and inflation compared to the central bank's forecasts from last July, as policymakers adjust their numbers for the effects of September 11.

Estimates for year-over-year, inflation-adjusted gross domestic product growth in the fourth quarter are now at 2.5% to 3%, vs. the 3% to 3.25% range previously expected. The estimate for the consumer price index, a broad gauge of inflation, is now at 1.5%, compared to an earlier 1.75% to 2.5% range. But the Fed adjusted its estimate for the unemployment rate higher, raising it to between 6% and 6.25% in 2002, vs. the 4.75% to 5.25% previous estimate.

LOOKING FOR SIGNS. Following Greenspan's testimony, Fed funds futures -- a trading vehicle for market pros to bet on future interest-rate moves -- rebounded from their pre-Greenspan lows and priced in lower odds of Fed tightening through the summer. The key July contract indicated only about a 75% probability that the Fed will have hiked rates by a quarter-point, down from nearly 100% earlier. Shorter-dated futures contracts continue to reflect a steady policy outlook through the spring.

Greenspan will have another opportunity to air his views in the second and final leg of his testimony, this time before the Senate on Mar. 7. But until the Fed sees concrete signs of a durable recovery, it will likely give growth a chance. Wallace is a senior economist for Standard & Poor's/MMS International

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