By Martin Wolk
msnbc.com
updated 7/20/2004 8:11:11 PM ET 2004-07-21T00:11:11

Federal Reserve Chairman Alan Greenspan delivered an upbeat midyear assessment of the economy Tuesday, declaring that an increasingly broad-based expansion has taken root, validating the central bank’s plan to continue raising interest rates gradually.

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Greenspan dismissed recent signs of economic weakness, particularly in consumer spending, saying they will likely prove to be “short-lived.” He was less sanguine about a recent increase in inflation which, he said, caused “considerable uncertainty.”

“Economic development in the United States has generally been quite favorable in 2004, lending increasing support to the view that the expansion is self-sustaining,” Greenspan said in testimony to the Senate Banking Committee. “Not only has economic activity quickened, but the expansion has become more broad-based and has produced notable gains in employment.”

In presenting the Fed’s semiannual report, Greenspan made his first public comments since the central bank’s decision June 30 to raise short-term interest rates for the first time in four years. The upbeat tenor of Greenspan’s remarks reinforced expectations that the Fed will continue to raise rates at what central bankers have described as a “measured” pace.

But Greenspan reiterated that the central bank “will do what is required” to keep inflation from rising too quickly, even if that means raising interest rates more aggressively.

“Financial markets, along with households and businesses, seem to be reasonably well-prepared to cope with the transition to a more neutral stance of monetary policy,” he said.

Stock prices rose modestly after Greenspan’s optimistic remarks; market interest rates rose as investors sold off Treasury securities. The benchmark 10-year bond, often used to set fixed mortgage rates, yielded 4.45 percent at the end of trading Tuesday, up from 4.36 percent Monday.

“The bond market had been thinking that the weak economic numbers that we’ve seen would cause the Fed to think twice about raising rates,” said Gary Thayer, chief economist at A.G. Edwards in St. Louis. “But it looks like Mr. Greenspan is saying the slowdown in the economy will be short-lived, and that suggests that the Fed will probably continue to raise rates.”

Kathleen Bostjancic, senior economist at Merrill Lynch, said she was surprised by Greenspan’s optimism, particularly after the soft data that emerged after the Fed’s rate decision was announced. The economy added only 112,00 jobs in June, about half what many economists had been expecting. Retail sales also fell last month, led lower by a surprisingly steep decline in car and truck sales.

“What struck the bond market and struck us was that he really dismissed the recent slowdown in economic activity that we saw in June,” Bostjancic said. “He said it’s just a temporary phenomenon.”

Greenspan blamed the downturn in consumer spending partly on higher prices for gasoline and other forms of fuel. But Bostjancic said there are no signs that gasoline prices are going to decline significantly anytime soon.

And the economy faces other headwinds, she and other analysts said. Tax cuts and mortgage refinancing that buoyed the economy over the past year are no longer providing any help, and the rising interest rates ultimately also will act as a drag on growth.

Sung Won Sohn, chief economist of Wells Fargo, agreed that such headwinds will hold back consumer spending. But he said rising business spending on new capital equipment and software would fuel strong growth in the second half of this year.

“I agree with (Greenspan) that this is a temporary soft patch,” Sohn said. “We will get more employment and jobs as businesses spend more money to rebuild inventories and spend money on capital goods.”

Sohn, however, expects only modest growth from the stock market, which has been stalled for several months despite strong corporate profits.

“The best news on the stock market is behind us,” he said. “We no longer have the tailwind of excess liquidity and low interest rates.” But he said the stock market will do reasonably well as long as the Fed does not raise rates so rapidly that it chokes off growth.

Greenspan said he was not concerned by Tuesday’s report that home construction slowed from its recent hot pace and fell in June to its lowest rate in about a year.

Underlying demand for housing is holding up well and there is no sign of a sudden slowdown as yet, he said.

“At some point we will slow down, but I see no evidence at this stage that a slowdown is occurring,” Greenspan said in response to a question from the Senate Banking Committee. “And as a consequence I think underlying demand for housing is going to remain reasonably solid, although presumably less than the peaks that we’ve seen in recent months.”

While bond prices fell Tuesday, some analysts said the market merely was unwinding a rally that had gone too far.

“All he was doing was righting the ship a little bit today,” said Ethan Harris, chief U.S. economist for Lehman Bros. He said the Fed chief’s testimony quelled speculation that the central bank might leave rates unchanged at its next meeting of policy-makers in August, rather than raise them a quarter-point as expected.

“They’ve got a nice simple path, and it’s going to take a lot to knock them off that path,” Harris said.

The Fed cut rates to a 1958 low of 1 percent by mid-2003 after a 13-step process that began in 2001. At its last policy session on June 29-30, it began reversing course by lifting its official federal funds rate a quarter percentage point.

More rate rises are expected later this year, though analysts are divided about the number and size. Greenspan said policy-makers will be keeping a close eye on costs and prices as it weighs whether a faster-operating economy generates more cost pressures.

Reuters contributed to this report.

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