The Federal Reserve may need to raise interest rates to head off the risk of accelerating inflation despite a slowdown in economic growth over the last few months, Mr Alan Greenspan, the US central bank chairman warned yesterday.
Mr Greenspan said a number of "cross currents" were affecting the US economic outlook, including the continuing impact of the Asian financial crisis.
But he cautioned that the risk of a resurgence of wage pressures in exceptionally tight labour markets was the principal threat to the seven-year US expansion.
"Should pressures on labour resources begin to show through more impressively in cost increases, policy action may need to counter any associated tendency for prices to accelerate, before it undermines this extraordinary expansion," Mr Greenspan told a Senate banking sub-committee in the first day of his half-yearly Humphrey-Hawkins testimony on US monetary policy.
His remarks prompted a drop in stock prices, as investors adjusted to a somewhat more hawkish tone from the central bank than they had heard in recent months.
Mr Greenspan's comments knocked the Dow Jones industrial average down. The Dow closed down 105.56 points at 9190.19. Prices of inflation-sensitive US bonds were little changed. Mr Greenspan noted the economy had slowed substantially in the three months to June, after growth at an annual rate of around 4 per cent in the previous year.
A sharp fall in the pace of inventory growth was the main reason for the deceleration but the impact of the Asian crisis on trade had been significant.
Over the rest of the year, the Federal Reserve expected growth to resume but at a more moderate pace, as the Asian effect continued. However, if growth did not slow sufficiently of its own accord, the Fed would step in and raise rates.
Mr Greenspan's remarks contrasted with his last report to Congress in February when he said risks to the economy were evenly balanced between faster inflation and a sharp slowdown. This time he seemed to remove any possibility that the Fed might lower interest rates this year, as some economists have forecast, in response to a slowing economy brought on by the Asian crisis.
But the Fed chairman acknowledged US monetary policy was constrained to some extent by events elsewhere.
"In the current circumstances, we need to be aware that monetary policy-tightening actions in the US could have outsized effects on very sensitive financial markets in Asia," he said.
However, domestic policy considerations would ultimately determine the Fed's interest rate policy. The Fed's policy-making Federal Open Market Committee has held US interest rates steady since March last year.
The Fed expects growth this year of 3 per cent to 3.25 per cent, falling to between 2 per cent and 2.5 per cent next year.
Consumer prices are expected to rise by 1.75 per cent to 2 per cent this year and by 2 per cent to 2.5 per cent in 1999.
Unemployment, which has fallen to near its lowest level in almost 30 years, is forecast to remain around 4.5 per cent to 4.75 per cent this year and next.
Mr Greenspan again referred obliquely to stock prices. Recent indications of weakening profit margins could force stock prices, he suggested, "to adjust to a less optimistic view of earnings prospects".
"Mr Greenspan presented a very balanced view. I believe the Federal Reserve is willing to wait to see how the economy performs in the second half of this year," said Ms Lynn Reaser, economist at NationsBank. "He does not want to fire up equity and bond markets, which could fuel even more consumer spending," she added.