Updated from 3:23 p.m. EDT

Federal Reserve Chief Alan Greenspan told the Senate Banking Committee Tuesday that deflation is no longer a problem and that the banking industry is well prepared for higher interest rates. The speech sent stocks and bonds spiraling lower.

"He's certainly paving the way for the Fed to go to a balanced risk assessment in May," said Stuart Hoffman, chief economist at PNC Bank. "He's trying to communicate to the markets that with the economy on a more solid footing" the Fed's patience may be running out.

Although Greenspan didn't specifically discuss the outlook for monetary policy in his speech, he said the financial system is "adequately managing its interest rate exposure."

"Many banks indicate that they now either are interest-rate neutral or are positioned to benefit from rising rates," he said. "Banks seem to believe that as rates rise -- presumably along with greater economic growth -- they can increase lending rates more than they will need to increase rates paid on deposits."

Although there are exceptions and some banks will be hurt by rising rates, Greenspan said the industry as a whole "appears to have been sufficiently mindful of interest rate cycles and not to have exposed itself to undue risk."

Stocks fell sharply in the wake of the remarks, with the Dow falling 123 points, or 1.2%, to 10,319 and the Nasdaq off by 42 points, or 2.2%, to 1979. The yield on the 10-year note rose to 4.45%.

Steven Wieting, senior economist at Smith Barney, said some investors had been expecting Greenspan to calm fears about a near term rate hike. Instead, he said, the comments were much more balanced.

In the question-and-answer session following the testimony, Greenspan said "deflation is no longer an issue," and that pricing power "is gradually being restored." He also noted, however, that inflation is "reasonably contained" because productivity is strong and labor costs are still declining.

"Any notion that we'd get a complacent view tomorrow was not at all suggested in these Q&A remarks," Wieting said.

Greenspan is scheduled to testify before the Joint Economic Committee on Wednesday.

Although the Fed has vowed to remain patient in raising rates, analysts now believe a rate hike will come as soon as August, citing evidence of a pick up in the job market and recent signs of inflation.

The latest employment report showed that 308,000 new jobs were created in March, the best performance in four years. Meanwhile, the consumer price index rose 0.5% last month, much more than expected and almost twice the 0.3% rise seen in February. Excluding food and energy, the CPI rose 0.4%, twice the gain in February.

Still, a batch of weaker than expected data late last week and dovish comments from Richmond Federal Reserve Bank president J. Alfred Broaddus and Fed governor Ben Bernanke helped to cool expectations for a rate hike shortly before Greenspan's testimony. Broaddus said that data pointing to a stronger economy is still "limited" while Bernanke told reporters that the recent rise in consumer prices isn't necessarily a sign that inflation is about to accelerate.

Greenspan said Tuesday that the banking industry has been very resilient over the last few years, particularly given external shocks such as the September 11 attacks, Argentina's credit default and economic pressures. He said companies seem to have devoted more effort and resources to contingency planning.

Nevertheless, the Fed Chief sounded a note of caution about credit risk-management practices related to construction projects and to the financing of commercial real estate, which have grown rapidly, particularly among regional and community banks. Such lending represented almost 19% of all bank loans at year-end 2003.

"At least, we see as yet no signs of rising credit losses from such lending.... Nonetheless, the historical record provides ample evidence of the risks associated with this form of lending.... Supervisors continue to monitor these concentrations and the lending practices and market conditions that will ultimately determine their effects on the banking system."

Greenspan also noted that while consolidation among banks has "slowed sharply" in the last five years, "a recent uptick in merger announcements, including a couple of very large transactions, may signal a return to a more rapid pace of bank merger activity."

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