Greenspan Acknowledges Potential for Excessive Slowdown

Fed Chairman Alan Greenspan acknowledged in a speech today that the combination of high energy prices, falling stock prices and rising interest rates for private borrowers has the potential to slow the pace of economic growth too much. His words suggest that the Fed will lower interest rates in the months ahead.

"[I]n an economy that already has lost some momentum," Greenspan said, "one must remain alert to the possibility that greater caution and weakening asset values in financial markets could signal or precipitate an excessive softening in household and business spending."

In his first speech on the economy and monetary policy since Oct. 19, Greenspan dwelt on the forces that have caused economic growth to slow and have the potential to slow it even more.

The 50% rise in oil prices this year, from about $20 a barrel in January to about $30 recently, is key, Greenspan said.

"In periods of transition from unsustainable to more modest rates of growth, an economy is obviously at increased risk of untoward events that would be readily absorbed in a period of boom," he said. "The sharp rise in energy prices, if sustained, is worrisome in this regard."

Lowering interest rates to blunt the impact of rising energy prices on the economy can lead to higher inflation, as it did in the 1970s, Greenspan cautioned. But in the current episode, "the most significant effect to date from higher energy prices appears to be on profit margins, where corporate businesses, constrained by competitive market forces, have not been able to raise prices to fully offset energy cost increases."

The resulting erosion in corporate earnings is behind the fall in stock prices, and falling stock prices are curbing consumer spending by dampening consumer confidence, Greenspan said. "The 'wealth effect' that spurred consumer spending is being significantly attenuated," he said. Consumer spending is the largest component of the economy.

The stock market has reacted favorably to Greenspan's comments. At midday, the Nasdaq Composite was up 214 points, or 8.2%, to 2829 and the Dow Jones Industrial Average was up 301 points, or 2.9%, to 10,860.

At the same time, earnings erosion has caused investors in corporate bonds to demand higher interest rates from corporate borrowers. That has caused capital spending by businesses -- another major component of the economy -- to slow as well, Greenspan said.

Greenspan was careful to note, however, that the current state of affairs bears limited resemblance to the conditions that prevailed in the fall of 1998, when the Fed cut interest rates three times in rapid succession to restore health to the financial markets.

"Our current circumstances are in no way comparable to those of 1998," he said. "Financial markets have continued to function reasonably well, and credit continues to flow, although admittedly with reduced availability to less-than-investment-grade borrowers and at interest spreads sufficiently elevated to press on profit margins of those lower-rated borrowers. Both lenders and borrowers are reassessing their positions in light of an apparent uptick in domestic risks, but the palpable fear that dominated financial markets at the height of the crisis two years ago is not now in evidence."

Greenspan's remarks suggest that the Federal Open Market Committee will change its assessment of the risks facing the economy at its next meeting on Dec. 19, in what would be the first step in a process that could eventually lead the committee to lower rates.

In the statement it releases after its meetings, the FOMC opts for one of three assessments of the economy. Either the risk of rising inflation is paramount, or the risk of slowing growth is paramount, or the two risks are in balance. Since early 1999, the committee has declared inflation the greater risk. Greenspan's remarks suggest that the committee will either move to a risks-balanced assessment or declare slowing growth the greater risk.