By Martin Wolk Executive business editor
msnbc.com
updated 4/20/2004 5:44:55 PM ET 2004-04-20T21:44:55

Stock prices tumbled and bond yields rose Tuesday on the merest hint from Federal Reserve Chairman Alan Greenspan that interest rates will be rising in the future — never mind when and how much.

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In his first of two scheduled appearances on Capitol Hill this week, Greenspan said the banking industry was well-positioned for a climate of rising interest rates -- a comment that apparently spooked some investors even though market interest rates have been rising steadily for three weeks.

Greenspan, who will expand on his economic views Wednesday, also said deflation is no longer an issue for the Fed, which spent much of the past year concerned about the possibility of falling prices.

"It’s fairly apparent that pricing power is gradually being restored," Greenspan said in response to a question from the Senate Banking Committee. "It’s a change, as best I can see, that has been long overdue and most welcome."

Stock prices tumbled in the last hour of trading after Greenspan's remarks were reported, with the Dow Jones industrial average ending the session with a loss of 123 points, or 1 percent. The yield on the benchmark 10-year Treasury bond rose to its highest level since September.

"The fact that he was talking about the what-if scenarios if rates would rise implies that rates will rise, so that got people nervous," said Tony Crescenzi, chief bond market strategist for Miller Tabak & Co. "He has told us about this inevitability before. What we don’t know is the timing of the rate increase. That’s what we hope to find out tomorrow."

In his prepared testimony Tuesday, Greenspan stuck closely to the hearing topic -- an assessment of the health of the banking sector.

“In general, the industry is adequately managing interest-rate exposure,” Greenspan said.

“Certainly, there are always outliers, and some banks would undoubtedly be hurt by rising rates,” Greenspan added. “However, the industry appears to have been sufficiently mindful of interest rate cycles and not to have exposed itself to undue risk."

Traders said some investors were disappointed Greenspan did not reiterate the Fed's intention to be "patient" in raising interest rates, although he promised a fuller accounting of his economic views Wednesday, when he appears before the Joint Economic Committee of Congress.

"He was trying to reassure the market, but he didn’t say anything really new," said Sung Won Sohn, chief economist for Wells Fargo. "The market is nervous and jittery, so the natural momentum is down and not up."

Market expectations of a Fed rate hike have been growing since April 2, when the Labor Department reported that the economy added 308,000 jobs in March, the best performance in four years and a long-awaited sign of improvement. That was followed by news last week that retail sales were much stronger than expected in March, and consumer prices surged, even after excluding gasoline from the mix.

At the very least the Fed is expected to change the language of its policy statement after central bank policy-makers hold their next meeting May 4, to say that inflation risks are now at least equal to the risks of deflation.

“I’m sure they (Fed policy-makers) feel much more comfortable about where we are — that the economy is on the right track,” said Mark Zandi, chief economist for Economy.com, a forecasting firm.

He and others said that at least some of the surprising strength in March can be attributed to improvement in the weather, which helped trigger a sharp increase in construction and sales of building supplies.

And after spending much of last year fretting about the potential for deflation, or falling prices, few policy-makers seem concerned about the recent run-up in the Consumer Price Index. Excluding the volatile food and energy categories, the closely watched “core” CPI is at 1.6 percent, still well below the Fed’s presumed target of 2 percent.

The last time the Federal Reserve began raising interest rates in the early years of an expansion, Greenspan and his colleagues moved aggressively, boosting the benchmark overnight rate from 3 percent to 6 percent in the space of a year. That rapid move caught many market participants off-guard and nearly brought growth to a halt in early 1995.

Analysts say that type of aggressive tightening is unlikely this time around, in part because the inflation rate is much lower now than it was then.

Fed policy-makers “have a lot of room to be patient and tighten, but tighten very slowly,” Zandi said.

“(Greenspan) doesn’t want to see long-term rates rise too far, too fast,” he said. “He’d like to avoid the worst possible disasters out there.”

The Fed cut interest rates 13 times beginning in January 2001, bringing the benchmark federal funds rate to its current 1 percent, the lowest level in 46 years. Greenspan previously has warned that the rate eventually will have to be raised. But Fed policy-makers also have promised to be “patient” in removing the current monetary accommodation.

In a speech last month, Fed Gov. Donald Kohn mused that patience could mean simply that the central bank raises rates more gradually than in past cycles, Merrill Lynch senior economist Martin Mauro said in a research note.

“That’s not what we expect to hear, but we will be listening carefully,” Mauro said.

There are reasons to believe Fed policy-makers may be slower to change their colors. So the data showing stronger-than-expect growth mainly reflects only one month’s results, a point underscored Friday by Alfred Broaddus, president of the Richmond Fed.

“I think at this stage of the game, speaking strictly for myself, we need more confirmation,” he said. “We must wait a little longer before we make judgments on whether or not the reports of the March economic data will persist or not. I think it will, and the likelihood is pretty high.”

He said the Fed is “some distance” from conditions that would require a rate hike.

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