Straight Talk from Greenspan

In an unusually clear manner, the Fed chief reiterated a plan for measured hikes but vowed quick action if inflation risks rise

By Michael Wallace

Federal Reserve Chairman Alan Greenspan stuck to his recent script in a presentation before the International Monetary Conference in London on June 8. In prepared remarks, he reiterated the central bank's current mantra of "measured" interest rate hikes based on the current economic outlook. So far, so good. But then came a hawkish bolt from the blue: The chief went on to say that if the Fed's inflation forecast is wrong –- as in, too low -- policymakers "will do what is required to achieve price stability."

References to traditional central banking themes of price stability and a higher consumer price index (CPI) were enough to make the bond market think the Fed might be ready to act sooner or with more force than is widely expected. The idea that Greenspan & Co. may embark on a more aggressive tightening trajectory sent Treasury prices sharply lower, pushing yields higher.

In his remarks, the Fed chief also noted that U.S. fixed-income yields have already done some of the heavy lifting, rising in advance of the tightening cycle, which wasn't the case back in 1994. Greenspan sees business hiring and a return of pricing power as positive signs, though some caution remains. He noted that the rise in energy prices could boost both core and overall CPI, though he welcomes recent energy price declines.


  After his small shocker, the Fed chairman went on to address the potential impact of higher rates on the housing sector. Greenspan sees little risk of any secondary concussions from the mortgage-debt market, which has "largely adjusted" to the prospect of rate increases. He indicated he doesn't foresee any financial grenades going off in the mortgage sector as rates continue to rise, and that he remains comfortable with the positive outlook on the housing sector.

During the panel discussion in London, the chairman struck a slightly more confident tone on the overall prognosis for inflation than he did during his prepared remarks. He noted that globalization, competition, and productivity have helped dampen price pressures –- macro trends he expects to remain in place. In contrast, he warned that protectionism would have the opposite effect.

Overall, he said the outlook is for stable, or close to stable, prices, though the Fed has to be vigilant for any "inconsistent events." Despite his reassurances, the bond market was jittery after hearing him express doubts about the policy and inflation mix earlier in the day. Still, the market expects the Fed to raise rates a quarter point to 1.25% at the end of the month, the first rate hike in nearly a year.


  Greenspan also said he continues to expects a positive mix of productivity gains and gross domestic product growth trending above 3% (at an inflation-adjusted annual rate) and reiterated that this is consistent with a "measured" rate-hike pace. He says he doesn't foresee a big surge in economic activity to create problems with that forecast.

He also responded that the short-run impact on monetary policy from the budget deficit was "benign," but that the long-term effects were due to the retiring baby boom generation -- a considerable concern from 2015 and beyond.

The Fed chief's June 8 appearance had one other item of note. Greenspan provided a subtle message to speculators, appearing to be keen to let them know that he's on to them in a couple different sectors, judging by the subtext of his London speech. First, he noted that "the marked rise in the net long positions of noncommercial investors in oil futures and options since May, 2003, has increased net claims on an already diminished global level of commercial crude and product inventories."

That's about as specific as the chairman ever gets in referring to futures markets. The fact that oil has already fallen to below $37 a barrel from a recent high of $42 suggests that some of these speculators are getting the message in the wake of OPEC's latest agreement to increase production.


  Second, Greenspan referred to the unwinding of "carry trades" -- popular leveraged trades in the bond market in which speculators borrow at short-term rates to invest in longer-dated, higher-yielding bonds. The trade is quite profitable until short-term rates begin to rise. The Fed chief seemed to be signaling in an unusually public fashion that he's paying attention to this activity.

Greenspan can be quite direct when he wants to be, and he seemed unusually forthright in his June 8 remarks, which come as the markets prepare for the central bank to begin a tightening cycle to rein in inflation and, just as importantly, rein in inflation expectations.

Wallace is global market strategist at Action Economics

Edited by Beth Belton

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