WASHINGTON -- Federal Reserve officials raised short-term interest rates this year in part to quell the speculative flood of money into stock and bond mutual funds as investors reached for higher yields, Fed Chairman Alan Greenspan said Friday.
Testifying before the Senate Banking Committee, Greenspan said Fed policymakers believe they must act to ensure stable financial markets as well as contain the threat of inflation when they set rates.
Greenspan's testimony failed to mollify leading Senate critics of the Fed's rate increases, who hammered him repeatedly for seeking to slow the economy at the expense of jobs and income for ordinary Americans. "If you see the economy come back out of the water to catch its breath, you push it right back down again," said Sen. Paul Sarbanes, D-Md.
Critics of the Fed have charged occasionally that the central bank is a captive of financial markets, forced to raise rates when in fact government reports show inflation pressures continue to ease. Consumer prices compared to a year earlier were up only 2.4% in April.
Greenspan admitted that Fed officials were worried at the beginning of the year about what he called "investor complacency" as low short-term rates fueled booming stock and bond markets. Stock and bond funds attracted $281 billion in 1993 alone, including money from safer, lower-yielding money in banks, he said.
Fed officials believed that after financial markets absorbed the first three short-term rate increases this year, they were in a better position to absorb the May 17 increase in the federal funds to 4.25% from 3.75% Greenspan said. "Indeed, they reacted quite positively."
Greenspan defended the Fed for not moving more aggressively with larger rate increases earlier in the year. "Many of us were concerned that a large immediate move in rates would create too big a dose of uncertainty, which could destabilize the financial system, indirectly affecting the real economy," he said.
Under questioning from skeptical senators, Greenspan sought to refute charges that the Fed is seeking to cool the economy. "We are not against growth, on the contrary," he said.
Greenspan argued that increasingly Fed officials believe if inflation is kept down, they can help increase productivity and ensure long-term growth. However, he declined to be pinned down on how fast officials believe the economy can grow. "It's a far fuzzier issue than some rigid number," he said.
Many economists believe the central bank wants to get growth down to a rate of about 2.5%. Indeed, the bond market sold off again on Friday after the Commerce Department said that gross domestic product rose a revised 3.0% in the first three months of the year, up from the 2.6% gain initially reported.
The GDP report reinforced the notion that the economy is continuing to grow at a solid clip and may in fact be picking up speed after taking a breather because of the bad weather and other special factors. That could induce the Fed to tighten credit once again, raising the federal funds rate to 4.5% from 4.25% at the July meeting of the Federal Open Market Committee.
Robert Dederick, chief economist for Northern Trust Co., said he believes economic growth could be as high as 4% in the second quarter. Dederick and other analysts noted that the revised first-quarter GDP figures showed less of an upturn in business inventories, suggesting there is more room for companies to step up production.
But members of the Banking Committee complained that Greenspan and his colleagues have failed to give a comprehensive rationale for tightening credit that can be explained to voters.
Sarbanes held up large posterboards with cartoons that made fun of Greenspan, with one depicting him carrying a protester's signboard saying, "The economy is picking up. We are doomed." Another poster showed him stomping out a garden sprout that represented the economic recovery.
The senators said they did not share the bond market's view that the economy may be overheating. Several cited recent statistics showing weakness in orders for durable goods and retail sales, and they said that higher rates are already choking off housing sales.
The Fed's rate increases "risk having a withering effect on this economic recovery that we've waited so long for," said Sen. Jim Sasser, D-Tenn.
Sasser, who is chairman of the Budget Committee, said Fed officials are carrying out a restrictive monetary policy at the same time as the economy is being squeezed by federal budget restraint. He cited recent estimates that President Clinton's budget may cut the deficit by as much as $600 billion to $650 billion over five years, well above the $500 billion that was originally foreseen.
"We've done our work. We've tightened fiscal policy. We've tightened down on spending, and we're asking the Fed to be partners with us in attempting to pursue a liberal monetary policy to give this economy enough oxygen to keep us growing," Sasser said.
"It is my own view that we now need a pause in rate changes to allow the economy to digest the policy moves you have already made," said committee chairman Donald Riegle, D-Mich.
Greenspan said he believes markets have now largely adjusted to the Fed's rate increases, and he expressed the hope that inflation will be contained. "If we are successful, there will not be an increase in overall inflation, and trends toward price stability will be extended," he said.
