Fed chief sounds inflation warning

WASHINGTON -- Federal Reserve Chairman Alan Greenspan issued a warning on inflation Wednesday, suggesting that the low U.S. unemployment rate may push wages and prices higher and that U.S. stocks are overvalued.

"Job growth slowed significantly in August and September, but it did not slow enough," Greenspan said in testimony to the House Budget Committee. "Thus the performance of the labor markets this year suggests the economy has been on an unsustainable track."

Stocks and bonds slumped on Greenspan's comments, which also included a warning that investors in stocks may be too sanguine about the inflation risk he sees. "Financial markets seem to have priced in an optimistic outlook characterized by a significant reduction in risk and an increasingly benevolent inflation process," he said. Because of that, the Fed chairman said stock price-earnings multiples are at levels "not often observed at this stage of economic expansion." In addition, he said "it would clearly be unrealistic to look for a continuation of stock market gains of anything like the magnitude of those recorded in the past couple of years." At the same time, Greenspan suggested that real interest rates could fall if government spending as a share of the economy shrinks. Real bond yields -- the after-inflation return -- "still are significant," he said. "There is, thus, doubtless a lot of catching up to do." Some economists saw little new in what Greenspan said. The Fed "is going to be vigilant," said David Resler, chief economist at Nomura Securities International Inc. in New York. "That's something he's said before," Resler said. "He's kind of reminding people we can't afford to be complacent." In fact, Greenspan did make a point Wednesday of saying a slowdown now under way could "close the gap and avoid the emergence of inflationary pressures." Also Wednesday, the Commerce Department reported wholesale inventories rose a larger-than-expected 1.0 percent during August, as businesses coped with sluggish sales. That followed a 0.7 percent drop in July inventories. Slowing sales pushed up the inventory-to-sales ratio, which measures the time goods sit at wholesalers, to 1.27 months during August from 1.24 months in July. And Tuesday, the Fed reported borrowing by U.S. consumers increased at a slower-than-expected pace in August, further evidence the economy is cooling. Consumer credit rose by $4.3 billion for the month, less than the $6.0 billion increase in July. That may be a sign households are paring back on spending and being more cautious with their finances. Consumer spending accounts for two-thirds of overall economic activity. Greenspan noted Wednesday "there is still little evidence of wage acceleration," and manufacturing productivity "did pick up some" in the third quarter, which would hold down inflationary pressures. "It's a wake-up call to the markets," said Josh Feinman, economist at Bankers Trust in New York. "Investors are assuming the best of all possible worlds, but bad things can still happen." Indeed, Greenspan all but said they would. With the U.S.unemployment rate at 4.9 percent, "to believe that wage pressures will not intensify as the group of people who are not working but who would like to rapidly diminishes strains credibility," he said. "The law of supply and demand has not been repealed." The unemployment rate "has a downside limit" because unemployment in part reflects periods of voluntary job search and includes people whose skills aren't well adapted to employer needs, Greenspan said. The costs of hiring those workers, or attracting employees from among early retirees, students or homemakers who don't now want jobs, could push labor costs higher. "That would trigger renewed price pressures, undermining the expansion," Greenspan said. U.S. companies are already problems finding enough workers. People "used to come walking in the front door" looking for a job, said Dan Evans, chief executive Officer of Bob Evans Farms in Columbus, Ohio. "Now we have to go out the front door and find them." Greenspan also warned against a wholesale embrace of a "new paradigm" in economic thinking -- that production capacity can be increased fast enough to meet expanding demand, holding down inflation. "We need to recall that it was just three years ago that we were confronted with bottlenecks in the industrial sector" that were "putting visible upward pressures on prices," he said. Even though business investment in new technology is producing productivity increases, he said, "this is clearly an evolutionary not a revolutionary process." The Fed chairman is warning that the inflation danger is tied to "biology not technology" -- the effects of the shortage of labor in an age that computers allow businesses to produce more, said William Sullivan, an economist at Dean Witter Securities in New York. "This is a reversal of his summer of `97 themes in which he seeming suggested there was a new era in productivity, a new paradigm," Sullivan said. "This is a complete about face where he questions the theme of new economy, and suggests that the business cycle is still in place." In that, Greenspan's testimony raises the question of whether he and his colleagues at the Federal Reserve believe it will be necessary to push interest rates higher in a bid to slow economic growth. During the first half of the year, the economy expanded at an annual pace of about 4 percent, at least one percentage point above the Fed's so-called speed limit. Last week, Greenspan and his colleagues at the Fed left the overnight bank lending rate unchanged at 5.5 percent. The Fed hasn't raised rates since March 25, when "persistent strength in demand" prompted central bankers to push up the fed funds rate by a quarter percentage point. And, although Greenspan said Wednesday the pace of job creation is still too fast, the Labor Department reported Friday that average weekly hours worked fell from August to September, and manufacturing overtime held steady. Coupled with slackening demand, that would suggest employers may be able to slow their hiring. So even if Greenspan sounded pessimistic, "it's unlikely his comments will translate into action anytime soon, not unless we see wage pressures starting to show up," said Nomura's Resler. Separately, Greenspan said Wednesday that the near-elimination of the federal government's budget deficit in the United States is a result of favorable market conditions and should only be considered a down payment for continued fiscal improvements. The Congressional Budget Office reduced last week to $23 billion its estimate of the federal budget deficit for the fiscal year that ended Sept. 30, the lowest in 23 years and more than $100 billion less than forecast by White House and CBO economists last year. If the CBO estimate proves to be correct, the fiscal 1997 deficit amounts to only 0.3 percent of the nation's gross national product, the smallest deficit as a percentage of GDP since 1970. Even so, Greenspan said higher inflation would slow the economy and jeopardize the positive budget developments. "A re-emergence of inflation is, without question, the greatest threat to sustaining what has been a balanced economic expansion virtually without parallel in recent decades," he said. Given that, Greenspan said, Fed officials recognize that their decisions on monetary policy "will be a significant factor influencing the path of economic growth and, hence, fiscal outcomes.

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