WASHINGTON -- Federal Reserve Board Chairman Alan Greenspan's testimony last week to Congress sent an unmistakable message that the bond market rally is over and interest rates are headed higher.

"The signal that we are endeavoring to send is that at some point rates are going to have to move up," Mr. Greenspan said in an uncharacteristically blunt statement to the Senate Banking Committee.

Normally, the Fed chairman declines to forecast interest rates and tip his hand on monetary policy. In this case, he wanted to make clear to Congress and the public that policymakers intend to move promptly when the next batch of troubling inflation statistics flit across bond dealers' screens.

Currently, inflationary pressures remain subdued. But Mr. Greenspan and his colleagues at the central bank have been deeply disappointed by their inability to get inflation below 3%, and they want to be ready to prevent prices from accelerating any more.

The shift in policy marks an end to three years of gradually trimming short-term rates in response to the credit crunch and a weak economy. And it means that Fed officials probably will raise the current federal funds rate of 3% to 3 1/4%.

Essentially, the bet at the Fed is that the economy will continue to improve gradually as consumers and businesses step up demand for credit and put upward pressure on interest rates.

As that happens, policymakers want to be set to form Policy quickly but gently so that they avoid the mistake of waiting too long to check rising price pressures.

Inflation Hawks

It is an evolution in thinking at the central bank that has not been without internal disagreement. According to one banking source, Federal Reserve Board Governors Wayne Angell and Edward Kelley have been calling for a move now on rates.

Mr. Angell is a well-known hawk who has been upset at the rise in gold prices. Mr. Kelley's tough stance raises interest because unlike most other board members, he is not an economist, and his views are often taken as reflecting mainstream thinking at the central bank.

At the same time, some of the Federal Reserve district bank presidents have been more inclined to be neutral on rates out of lingering concern about the soft economy, the source said.

Any rise in interest rates is likely to be gradual because the economy will not gain much steam in the months ahead. Mr. Greenspan conceded that small businesses continue to lack credit from their usual commercial bank sources, and defense cutbacks, among other things, will continue to be a drag on growth.

"Greenspan and the Fed do have time," said Charles Lieberman, managing director of Chemical Securities Inc.

"There is no inflationary problem today. And there is not likely to be a significant inflationary problem any time in the near future, meaning in the next six or 12 months. So Greenspan has the luxury of being able to move slowly on monetary policy."

Mr. Lieberman said he is looking for the Fed to bump up the federal funds rate to 4% by the middle of next year. But he said he doesn't expect any action before Labor Day, because price reports from the government are expected to be positive. By year-end, he is calling for yields on the Treasury long bond to be around 7%.

|Lock in Rates Now'

Such rate increases are not expected to have much impact on the economy. Still, the message for homeowners and businesses is to go to the credit markets now because rates will not get any lower.

In fact, rates edged up slightly last week in reaction to Mr. Greenspan's testimony. "Anybody who listened to what Greenspan said would be well-served to lock in rates now," said Mr. Lieberman.

One bright spot is the deficit-reduction package moving through Congress. The bond market's belief that the package will pass has contributed to the drop in the long-term rates, as have recent reports from the government showing price pressures were almost nonexistent in May and June.

The Bond Buyer is a sister publication of the American Banker.

Subscribe Now

Access to authoritative analysis and perspective and our data-driven report series.

14-Day Free Trial

No credit card required. Complete access to articles, breaking news and industry data.