Updated from 12:48 p.m. EST
Chairman Alan Greenspan presented an upbeat assessment of the U.S. economy Wednesday and said interest rates "will eventually need to rise toward a more neutral level."
In a speech before the House Financial Services Committee, Greenspan said the prospects for sustained growth in the economy are "good" and that employment growth will quicken "before long."
"In retrospect, last year appears to have marked a transition from an extended period of subpar economic performance to one of more vigorous expansion," he said in prepared remarks.
The comments sparked a minor rally in the
, which was recently up about 54 points to 10,668. Treasuries rose and the dollar slid against other major currencies.
Greenspan said monetary policy should remain accommodative to promote sustainable growth "but the evidence indicates clearly that such a policy stance will not be compatible indefinitely with price stability and sustainable growth; the real federal funds rate will eventually need to rise toward a more neutral level."
Such comments echoed remarks made by the Fed chief 10 years ago when he said "at some point absent an unexpected and prolonged weakening of economic activity we will need to move them to a more neutral stance." In 1994, the Fed embarked on a series of rate hikes.
Prudential economist Ed Yardeni said rates could move back up to 2% over the next 12 to 18 months, noting that this would be a "neutral standpoint." Interest rates are currently sitting at just 1%.
Still, Greenspan did note that with inflation low and substantial slack in the economy, the Fed can remain patient in raising rates. He also pointed to various risks that could threaten the economic expansion, including the sharp spike in oil and natural gas prices, which he referred to as a "chronic concern." In addition, Greenspan subtly hinted that stock prices may be overvalued.
Last year, broad equity prices rose 25% and technology stocks increased twice as quickly, he said. "However, history shows that pricing financial assets appropriately in real time can be extremely difficult and that, even in a seemingly benign economic environment, risks remain."
What's more, he noted that the outlook for the budget deficit is a "critical issue" in determining long-term growth prospects. The deficit rose to $375 billion in 2003 and is projected to swell to $477 billion in fiscal 2004.
"One critical element -- present in the 1990s but now absent -- is a framework of procedural rules to help fiscal policy makers make the difficult decisions that are required to forge a better fiscal balance," he said.
Unless fiscal issues are addressed soon, budget deficits could cause trouble even in the near term, he said, particularly because they accompany a current account deficit equal to 5% of gross domestic product.
So far, Greenspan noted, the current account deficit has been financed with little difficulty, as foreigners pour money into U.S. assets. But overseas investors may become less willing to invest here in the future if deficits continue to widen. Paul Kasriel, an economist at Northern Trust, has said previously that overseas investors could start to worry about how the U.S. will pay the interest it owes on the roughly $1.5 billion that it borrows from the rest of the world each day.
"Addressing the federal budget deficit is even more important in view of the widening U.S. current account deficit," Greenspan said. "Should investors become significantly more doubtful that the Congress will take the necessary fiscal measures, an appreciable backup in long-term interest rates is possible."
That view is at odds with the Bush administration, which has said the budget deficit does not pose a near-term threat to the economy.
reported earlier this month that Greenspan would deliver a tough speech on the federal budget deficit, which he privately considers "awful" and "quite frankly dangerous," according to the magazine's sources.
In another swipe against the Bush administration, Greenspan said protectionism is a significant threat to economic stability. "Creeping protectionism must be thwarted and reversed," he said.
The Bush administration recently scrapped steel import tariffs imposed in 2002 after the World Trade Organization ruled them illegal. However, the administration has said it would place quotas on certain Chinese textile imports.
While some analysts have grown concerned about the rise in personal debt over the past year, Greenspan said the rise in home and equity prices has enabled the ratio of household net worth to disposable income to recover to a little above its long-term average. He also noted that the household debt service burden has declined "a bit" and said many measures of consumer credit quality improved over the year.
The central bank released new forecasts for 2004 and now expects real gross domestic product to grow between 4.5% to 5% from the fourth quarter of 2003 to the fourth quarter of this year. Last July, policymakers had pegged real growth at 3.75% to 4.75% for that period.
The Fed also expects the jobless rate to show a small improvement, with the unemployment rate at 5.25% to 5.5% this year, compared with a forecast of 5.5% to 6% last year. The jobless rate stood at 5.6% in January.
Inflation is expected to remain under control, rising just 1% to 1.25% for the year. That's down slightly from last year's 1% to 1.5% prediction. Economists from Goldman Sachs said a downward revision to the jobless rate and upward move in the projected economic growth rate could change the market's perception about just how "patient" the Fed will be in raising interest rates. Instead, investors chose to latch onto dovish comments that current interest rates are "appropriate."