Greenspan Plays Grinch

Shares slip after the Fed chairman warns about housing and low risk premiums.
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Updated from 11:33 a.m. EDT

Clearly concerned about the economic legacy he will leave to his successor,

Federal Reserve

Chairman Alan Greenspan rang the alarm bells on what many -- though not the chairman himself -- call the housing bubble.

Speaking at the opening of a two-day meeting of central bankers in Jackson Hole, Wyo., Greenspan said that global economic activity in recent years has been heavily influenced by capital gains on various assets, and the liabilities that finance them.

"Our forecasts and hence policy are becoming increasingly driven by asset price changes," he said in prepared remarks.

Investors, Greenspan said, have increasingly accepted lower compensation for taking higher levels of risks, expecting stability over a long period of time. Lower risk premiums, he said, have fueled asset prices, including stocks, bonds and, more recently, houses. These gains have in turn been used to finance purchases.

Gains in asset prices are "too often viewed by market participants as structural and permanent

but what they perceive as newly abundant liquidity can readily disappear," the Fed chairman said.

If investors turn more cautious and risk premiums start rising, the value of assets would fall and encourage the liquidation of the debt that supported the higher prices. "This is the reason that history has not dealt kindly with the aftermath of protracted periods of low risk premiums," Greenspan warned.

Major averages turned lower in initial reaction to Greenspan's comments but losses thus far have been modest. The

Dow Jones Industrial Average

was recently down 0.4% to 10,408.21, the

S&P 500

was lower by 0.4% to 1207.11 and the

Nasdaq Composite

was down 0.5% to 2123.50.

Predictably, housing-related stocks such as

Toll Brothers

(TOL) - Get Report

were among the weaker sectors in reaction to Greenspan's comments. The Philadelphia Stock Exchange Housing Sector Index was recently down 1.2%.

Rectifying Imbalances

The Fed chairman also warned that developing protectionist trends and unsustainable fiscal policy were threatening the flexibility of the economy, "our most valued policy asset," which has "fostered our extraordinary resilience to shocks."

This flexibility is necessary to help rectify America's economic imbalances -- including the current account deficit and the housing boom -- through adjustments in prices, interest rates and exchange rates, instead of growth, incomes and employment.

Bond prices barely budged despite the implications of the chairman's remarks, which all but confirmed that the Fed will continue raising short-term rates at a measured pace for the foreseeable future.

The benchmark 10-year Treasury bond was recently down 3/32 while its yield rose to 4.17%.

"It's not that the Fed is targeting house-price appreciation, it's the consumption it has generated and the implications that has for inflation down the line," says Michael Gregory, interest rate strategist with BMO Nesbitt Burns.

Still, the bond market has been rallying -- and yields used to benchmark mortgage rates have fallen during August, on expectations that surging energy prices will crimp economic growth and inflation down the line.

Confirming this trend Friday, the latest reading on consumer sentiment from the University of Michigan showed a worse-than-expected decline from July.

According to Gregory, Greenspan is willing to continue lifting short-term rates past the level of the 10-year bond's yield, which would resulted in an inverted yield curve. While this phenomenon has often signaled a looming economic recession, Gregory believes that this time is different. "The Fed is not really tightening the monetary screws right now, it is simply returning short-term rates to a neutral level," he notes.

In keeping with TSC's editorial policy, Godt doesn't own or short individual stocks. He also doesn't invest in hedge funds or other private investment partnerships. He appreciates your feedback;

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