Updated from 10:57 a.m. EDT

Fed

Chief Alan Greenspan spoke bluntly Tuesday about corporate corruption and the impact it could have on the nascent economic recovery, but managed to balance his tone enough to avoid shocking the market anew.

After plunging more than 400 points Monday, the

Dow

and other market proxies rallied back, partly on hopes that Greenspan would say something to raise investors' sprits. Tuesday morning's stock action was similar in direction but instead of accelerating, as it did when President Bush began a speech, the selling cooled off when Greenspan spoke.

Although Greenspan noted that "the fundamentals are in place for a return to sustained healthy growth," he added that an "infectious greed" has gripped the financial community.

"Fraud and deception are thefts of property," he said. "Unless the laws governing how markets and corporations function are perceived as fair, our economic system cannot achieve its full potential."

Return of the Maestro

Steve Weiting, an economist at Salomon Smith Barney, said Greenspan walked a fine line. "It's very different from the perceptions that he could say something to prop up the markets to stem the slide, when the reality is, he faced all the issues and didn't sugar-coat them in any way at all," Weiting said.

Greenspan stated that "previously undiscovered misdeeds will no doubt continue to surface in the weeks ahead as chastened CEOs restate earnings." But he also suggested that stiffer penalties should be adopted to punish corporate fraud and said profitable opportunities for fraud have diminished markedly.

"Maybe some investors were hoping for some more forceful words that the Fed is prepared to do something about the decline in the stock market," said Kenneth Kim, an economist at Stone McCarthy Research. "Again, these are just words rather than actions, kind of what President Bush has been faulted for."

When Bush spoke about the issue of corporate responsibility last Tuesday, the stock market plunged as the speech failed to instill confidence in investors. On Monday, Bush said the economic fundamentals are sound but that the U.S. is suffering from a "hangover" after the "economic binge" of the 1990s.

Rudderless

Still, Bruce Kasman, an economist at J.P. Morgan, said it wasn't obvious what the market wanted to hear from Greenspan's testimony. "There was no clear expectation of what he needed to do," he said.

Kasman said the speech was reasonably upbeat and "conventional." The Fed chief suggested that while there are some drags on the economy, most notably the corporate governance issues, inflation is currently contained and profit margins are coming up from their lows. He also noted that business spending should increase as sales pick up.

"He talked about

questionable accounting as something that could slow things for a while, but he didn't talk about it with a real sense of concern that this is creating a different type of environment than we've seen before," Kasman said. "He was generally upbeat that the basic thrust of the economy is going forward and is going to gather momentum over the coming few quarters."

In fact, the Fed raised its forecast for economic growth to 3.5% to 3.75% this year, faster than the 2.5% to 3% growth forecast in February. Fed policymakers are also looking for growth of 3.5% to 4% next year as the unemployment to fall to 5.25% to 5.5%.

Greenspan said that because the economic recovery has been less vigorous than in the past, the Fed has chosen to maintain an accommodative stance. The Federal Open Market Committee's 11 rate cuts have left the fed funds rate at a forty-year low of 1.75%.

Accommodation

Kim, who had been looking for a potential rate hike later this year, says he now sees almost no chance of that happening.

"The problems facing the U.S. are not going to dissipate over the near-term," he said.

On the issue of stock options, Greenspan said that they "perversely created incentives to artificially inflate reported earnings in order to keep stock prices high and rising" during the late 1990s. But options "failed to properly align the long-term interests of shareholders and managers."

"It is not that humans have become any more greedy than in generations past. It is that the avenues to express greed had grown so enormously," he said.

Turning to the dollar, which has continued to fall against foreign currencies and recently fell below one euro for the first time since February 2000, Greenspan said forecasting exchange rates is perhaps more difficult than almost any other economic variable.

Real interest rates, changes in productivity and external deficits have not been "consistently useful in forecasting exchange rates even over substantial periods of one or two years," he said.

After falling sharply in early trade Tuesday, stocks recouped much of their losses by midday, with the Dow trading down just 50 points to 8,588. The

S&P 500

fell 3 points to 914, but the

Nasdaq

was up 18 points, or 1% to 1400.