Updated from 11:36 a.m. EDT

Fed

Chairman Alan Greenspan stuck to his upbeat -- and hawkish -- script Wednesday, saying that the economy is strong enough to allow the Fed to continue raising interest rates.

The Fed's "baseline outlook" is that the U.S. economy remains on a path of "sustained economic growth and contained inflation pressures," Greenspan said in

prepared remarks to Congress for probably the last semiannual testimony of his tenure as Fed chief.

"In our view, realizing this outcome will require the Federal Reserve to continue to remove monetary accommodation," Greenspan said.

On average, Greenspan was "as hawkish as expected," according to Joel Naroff, president of Naroff Economic Advisors. "It's fairly clear that, on balance, the Fed's concerns are tilted towards inflation risks, which argue more for raising interest rates than for stopping."

Financial markets had a somewhat subdued reaction to Greenspan's comments, at least compared with his prior congressional testimony. Still, the dollar rose to a 14-month high vs. the yen and gained vs. the euro as well, while the price of the benchmark 10-year Treasury fell fairly sharply in initial reaction. Having somewhat pared those early losses, the benchmark note was recently down 7/32 in price, its yield rising to 4.21%.

While Greenspan's remarks didn't create a major surprise, some fixed-income trader were (wrongly) betting Greenspan might hint the Fed may soon pause its year-long campaign to raise rates, according to Darin Feldman, fixed-income portfolio manager at Aladdin Capital.

Major stock proxies trimmed early losses in reaction to Greenspan's testimony, which perhaps wasn't as hawkish as some traders feared. The

Dow Jones Industrial Average

was recently down 0.3% to 10,611.15 vs. its earlier low of 10.581. The

S&P 500

was off 0.3% to 1226.98, while the

Nasdaq Composite

was down 0.2% to 2167.79 as strength in

Amgen

(AMGN) - Get Report

helped offset weakness in

Yahoo!

(YHOO)

and

Intel

(INTC) - Get Report

.

Looking back, it is the Fed's belief that soaring energy prices created a temporary "soft patch" in the U.S. economy earlier this spring, Greenspan commented. But "the data released over the past two months or so accord with the view that the earlier soft readings on the economy were not presaging a more serious slowdown in the pace of activity," he said.

"Employment has remained on an upward trend, retail spending has posted appreciable gains, inventory levels are modest, and business investment appears to have firmed. At the same time, low long-term interest rates have continued to provide a lift to housing activity."

Likewise, Greenspan focused on the "balanced" aspect of current inflation pressures, noting "prices of crude materials and intermediate goods have softened of late" and the strength of the dollar should slow the rise of import prices.

But there the Fed chairman once again put on more emphasis on future inflation risks stemming from rising labor costs, slowing productivity and the continued stimulus to household wealth provided by low long-term interest rates.

"Household spending -- buoyed by past gains in wealth, ongoing increases in employment and income, and relatively low interest rates -- is likely to continue to expand," Greenspan said.

For Ian Shepherdson, chief U.S. economist at High Frequency Economics, the key priority emphasized by Greenspan is labor costs. "Greenspan is not sure how much of this is real and will be sustained but he simply cannot afford to take chances," he wrote in a note after the release of the text.

Greenspan's testimony also went on at length about the "conundrum" of long-term interest rates remaining low while the Fed has continued to raise short-term rates. He again said that these low long rates were likely the result of global excess saving being invested in Treasury bonds.

But the main result has been to keep mortgage rates low, which continues to fuel demand for homes, home-price appreciation and consumer spending, in spite of the Fed rate hikes over the past year. The so-called neutral level of short-term interest rates, which the Fed would consider neither stimulating nor restricting growth, still remains undetermined.

"Result: Short rates have to keep rising," says Shepherdson. "There is no discussion here of where the Fed might stop, or what neutral might be, but the clear message is that it is some way from here."

According to Miller Tabak, fed funds futures for the first time have started pricing in that they would stand at 4.25% after the Fed's first meeting next year on Feb. 1. The market was already pricing in 4% by year-end, which implies three more rate hikes at the Fed's remaining four meetings this year.

As part of that reassessment, the yield of the 10-year Treasury bond is now poised to continue drifting higher over the next couple of weeks, says Larry Berman, fixed-income strategist at CIBC World Markets.

The market will want to test the yield's resistance level at 4.3%. "Should that level break, we should then revisit 4.9% before the end of the year," Berman says.

The 10-year approaching 5% might be enough to slow down demand for homes, at least at the margin. But as shown by the strength of homebuilding stocks, that's not a concern for now. The Philadelphia Stock Exchange Housing Sector Index was recently up 1.1%.

Toll Brothers

(TOL) - Get Report

was up 1.4%,

KB Home

(KBH) - Get Report

up 0.3%, and

Hovnanian

(HOV) - Get Report

up 0.9%.

"Investors in housing just don't care," with long-term rates still at these relatively low levels, Berman says. "It would take a 200-basis points move

in the yield of the 10-year to really have an impact."

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;

click here

to send him an email.