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Greenspan issues warning
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July 21, 1998: 12:42 p.m. ET
Markets jolted as Fed chief cites possibility of rising inflation, wages
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NEW YORK (CNNfn) - Mixing accolades and alarms, Federal Reserve Chairman Alan Greenspan hailed the American economy's "virtuous cycle" Tuesday, calling it the best he has seen in 50 years, but warned of lurking inflationary pressures and a potentially severe drag on future growth from Asia's turmoil.
In his semi-annual Humphrey-Hawkins testimony before the Senate Banking Committee, Greenspan said a tight labor market and the risk of accelerated inflation outweighed the downside from the effects of the Asian crisis.
Stepping into the fray of a heated political debate, Greenspan also urged Congress to approve an $18 billion increase in U.S. funding for the International Monetary Fund.
Greenspan made his position clear following his formal testimony, during a question-and-answer session with the congressional panel. In response to concerns voiced by Sen. Paul Sarbanes, a Democratic panel member from Maryland, over the depleted IMF reserves, Greenspan replied: "I certainly agree with you that they are down to rock-bottom levels."
The Dow industrials index initially plunged more than 50 points on the remarks as bond traders sent the 30-year benchmark Treasury up 3/32 in price.
But by midday, the Dow had staged a mild recovery, though the Dow was still down about 20 points. Treasurys continued their upward price march, however, rising 10/32 by midday for a yield of 5.70 percent.
Greenspan warned the Federal Reserve would have to raise rates if the economy doesn't slow down on its own, though the board has kept rates steady for the time being.
A mix of caution and kudos
Greenspan straddled a divide between caution and kudos for Wall Street, saying, essentially, that investors' expectations that low inflation and stronger productivity growth would allow profits to stretch into the "distant future" have, in some respects, become a self-fulfilling prophecy.
At the same time, he suggested that the market ebullience tended to blind investors to potential pratfalls as the economy chugs along. He noted that long-term corporate earnings projections for U.S. firms were probably unrealistic.
The rise in stock prices, Greenspan said, had added $12.5 trillion to household assets since the end of 1994. Nonetheless, Greenspan said GDP expansion had slowed sharply in the second quarter, dragged down by the strikes at General Motors, which shaved 0.5 percentage points off growth.
Greenspan said the effects of tight labor markets and wage pressures were offset and even exceeded in the first half by improvements in productivity.
But he stressed: "Notwithstanding a reasonably optimistic interpretation of the recent productivity numbers, it would not be prudent to assume that even strongly rising productivity, by itself, can ensure a non-inflationary future."
While emphasizing the unprecedented upward trends in the American economic cycle, which he said remain "impressive," Greenspan noted at several junctures that "important crosscurrents" have continued to buffet the economy.
He warned that Asia's troubles could intensify "and spread further," even as the threat of inflation remained "significant" amid a climate of tight labor markets.
Taking aim at Japan, the world's second- largest economy, Greenspan urged the government there to step up efforts to kick-start the country's sagging economy by cutting taxes and enacting other "stimulative fiscal policies."
"While we expect that the situation will develop relatively smoothly, the (Fed) believes that, given the current tightness in the labor markets, the potential for accelerating inflation is probably greater than the risk of protracted, excessive weakness."
The Fed chairman also sounded a note of caution on the economy's future trajectory, saying stock prices and credit spreads may be hard to sustain.
Asia effects not yet fully felt
Addressing Asia, Greenspan said the number of countries experiencing difficulties "is not surprising," and warned that "the risks of further adverse developments in these economies remain substantial" and that the full effects had not yet been felt.
"The extent and pace of recovery of Asian economies currently experiencing a severe downturn will have important ramifications for prices of energy and other commodities, the strength of the dollar, and competitive conditions on world product markets," Greenspan said.
The Fed chairman suggested that deferring IMF funding until the Asia crisis subsides would be akin to putting the cart before the horse.
"In my judgment, approving the quota is crucial to getting the IMF in a position to address other crises which may arise," he said. Evaluating the IMF's effectiveness as a financial-rescue squad, he added, is a process that should be put off to a later date, once the Asian crisis has abated.
Perversely, Greenspan said, the Asian crisis had actually contributed to the fortunes of the U.S. economy by helping to foster lower inflation and economic stability.
"The major concern that I have is that that obviously cannot continue indefinitely," he added.
Analysts described Greenspan's mood in terms of tempered admiration for an economy whose performance has taken even veteran economic gurus off guard.
At one point, responding to a question from Republican Senator Alfonse D'Amato of New York, the banking committee's chairman, Greenspan said U.S. bank lending practices had become looser than they should be, but that despite this, defaults have remained nil to minimal.
Such trends may lead to complacency over time, Greenspan said. Hence, his appearance on Capitol Hill Tuesday, analysts said, could be seen as an attempt to inject some wary skepticism into the steamrolling markets.
"He has issued a bit of a caution flag now that he's on the lookout for wage pressures," said Roger Kubarych, an analyst with Kaufman & Kubarych Advisers. 
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