Updated from 3:49 p.m. EDT
Chairman Alan Greenspan said super-low interest rates are becoming "increasingly unnecessary" and warned that monetary policy could be adjusted "in a less gradual manner" if inflation were to become a problem.
In testimony before Congress Tuesday, Greenspan said the economic expansion seems to be "self-sustaining" and that recent softness "should prove short lived."
"Not only has economic activity quickened, but the expansion has become more broad-based and has produced notable gains in employment," he said. "The considerable monetary accommodation put in place starting in 2001 is becoming increasingly unnecessary."
Greenspan reiterated that inflation has been boosted by transitory factors this year, like the surge in energy prices. He noted that these higher prices have crimped consumer spending so far, but said the impact should be temporary.
"Despite the softness of recent retail sales, the combination of higher current and anticipated future income, strengthened balance sheets, and still-low interest rates bodes well for consumer spending," he said.
In June, retail sales fell 1.1%, the biggest decline in 16 months. Meanwhile, job growth was much weaker-than-expected and the Institute for Supply Management's manufacturing and services indexes dipped last month from May's levels.
While it is likely that monetary policy neutrality can be restored "at a measured pace," Greenspan said it's possible that more aggressive action might be needed. Last month, Greenspan had said the Fed was prepared to do "what is required" to stem inflation.
"We cannot be certain that this benign environment will persist and that there are not more deep-seated forces emerging as a consequence of prolonged monetary accommodation," he said.
"If economic developments dictate that the stance of policy must be adjusted in a less gradual manner to ensure price stability, our economy appears to have prepared itself for a more dynamic adjustment of interest rates."
Greenspan did acknowledge, however, that raising interest rates quickly brings more risk and uncertainty than a more measured approach.
He also noted that the economic outlook is still cloudy. Although the labor market has improved in recent months, the proportion of temporary hires relative to total employment continues to rise, "underscoring that business caution remains a feature of the economic landscape."
Furthermore, the impact of potential terrorism both here and abroad is "hard to quantify" and could keep oil prices high. "In assessing the appropriateness of the stance of policy, the Federal Reserve will pay close attention to incoming data, especially on costs and prices," Greenspan said.
Despite a generally upbeat speech, the Federal Reserve tweaked its projections for growth, saying it now expects the economy to expand 4.5% to 4.75% from the final quarter of 2003 to the final quarter of 2004. In February, it forecast growth of between 4.5% and 5%. For 2005, the Fed expects the expansion to slow to 3.5% to 4%.
The central bank also said the personal consumption expenditure index, excluding food and energy, should rise 1.75% to 2% this year. In February, the Fed predicted that the PCE index, including food and energy, would hit 1% to 1.25% this year.
As for the unemployment rate, the Fed left its estimate intact, calling for 5.25% to 5.5%. For 2005, it predicted that unemployment would be in a range of 5% to 5.5%.
Equity investors reacted favorably to Greenspan's comments, sending the Dow up 55 points to 10,149 while the Nasdaq rose 33 to 1,917. Bonds on the other hand, declined, with the yield on the 10-year Treasury climbing to 4.44%, from 4.37% before the speech.
Richard Yamarone, an economist at Argus Research, said he still believes the Fed will go "slow and steady" this year.
"I don't think there was anything in the speech that was surprising," he said, adding that he expects another 50 basis points of tightening this year.
Yamarone said he is expecting economic growth to be uneven this year, noting that business will remain cautious around the time of the political conventions and the election.
Bob Gay, global strategist for Commerzbank Securities, agreed that the Fed will continue to move at a measured pace this year. "Inflation is probably not yet a problem for the Fed, they still have it under control thanks to spectacular productivity growth," he said, adding that he is calling for an additional 75 basis points of tightening this year.