Greenspan Warns Of Risks

In a balanced report on the state of the economy, Federal Reserve Chairman Alan Greenspan warned Tuesday that the U.S. economy faces "considerable upside and downside risks."

"Monetary policy must be ready to move quickly in either direction," Greenspan told the Senate Banking Committee. He cautioned that the Fed might have to raise interest rates to offset some of the continued stimulus from its three interest rate easings in the fall.

On balance, Greenspan's semi-annual Humphrey-Hawkins testimony gives no reason to think the Fed will stray from its current policy until something dramatic happens.

Greenspan's comments briefly knocked the broader stock market lower after a big pre-Greenspan rally on Monday.

In his semiannual review of the U.S. economy, Greenspan said the economy had once again "performed admirably" over the past year and expects another stellar performance in 1999, but he warned against complacency.

"After eight years of economic expansion, the economy appears stretched in number of dimensions," he said.

Greenspan sees four major threats to the continued expansion: tight labor markets that could spark inflation, high stock market prices, growing debt levels and fragile foreign markets.

"Equity prices are high enough to raise questions about whether shares are overvalued," he said. "Investors appear to have incorporated into current equity prices both robust profit expectations and low compensation for risk," he said, warning that disappointments on either score could "damp appetites for equities."

Despite those concerns, the Fed is forecasting U.S. growth to slow only moderately in 1999 to a 2.5 percent to 3 percent pace, with unemployment remaining at about 4.5 percent. Inflation is expected to pick up slightly to 2 percent to 2.5 percent.

While he stood by the Fed's decisions in September, October and November to ease policy, Greenspan said the actions might have added too much liquidity to the system.

He cautioned that the Fed would "continue to evaluate, among other issues, whether the full extent of the policy easings undertaken last fall to address the seizing-up of financial markets remains appropriate as those disturbances abate."

Greenspan made it clear the Fed is still vigilant about inflation.

"Labor markets remain exceptionally tight and the economy evidently retains a great deal of underlying momentum despite the global economic problems and the still-visible remnants of the earlier financial turmoil in the United States," he said. "At the same time, no evidence of any upturn in inflation has, as yet, surfaced."

If growth slows as forecast, he said, "underlying inflation pressures ... in all likelihood will not intensify significantly in the year ahead."

"Recent experience does seem to suggest that the economy has become less inflation prone than in the past" because workers fear losing thei jobs and businesses fear losing market share if they insist on higher returns.

If businesses cannot get more for their goods and services, then they must slash costs to keep profits up. Increased capital investment that makes companies more productivity, coupled with falling commodity prices, have given businesses the ability to resist raising prices, he said.

But eventually, the demand for labor will outstrip the available supply, he said. "It cannot continue for very much longer without putting increasing pressure on labor markets and on costs," he said.

If inflation is the biggest risk on the upside, the economy must meet several challenges that could sharply reduce growth.

The global economic situation is mixed, he said. Korea and Thailand appear to be recovering, but Russia isn't. He said Brazil's troubles haven't spread as much to other Latin American economies as feared, perhaps because investors had so much warning.

The risk remains, however. "The economies of several of our key industrial trading partners have shown evidence of weakness, which if it deepens could further depress demands for our exports," he said.

The stock market is another worry. A weaker stock market could slow both investment and consumption spending.

Investors have very rosy profit projections based on continued productivity-enhancing investments. But if "pressures on profit margins mount and capacity utilization drops," investment could slow.

"A downward correction to stock prices, and an associated increase in the cost of equity capital, could compound a slowdown in the growth of capital spending," he said. "In addition, a stock market decline would tend to restrain consumption spending through its effect on household net wealth."

Written By Rex Nutting, Washington bureau chief for CBS MarketWatch