Fed Chairman Warns Stock Investors Again

EXUBERANCE REVISITED

For a man known for obfuscation, Alan Greenspan is becoming increasingly blunt.

The chairman of the Federal Reserve delivered a sharp warning yesterday on the dangers of an overheated stock market - the third in three months. His message is raising new concerns that the central bank will at some point increase interest rates if the market doesn't settle down.

"The stock market needs to pay more attention to what he is saying," says Lyle Gramley, consulting economist of the Mortgage Bankers Association and a former Fed governor. "If this doesn't do it, there will be blunter warnings later."

At least temporarily, the market did pay heed. After his remarks to the Senate Banking Committee, stock prices dipped sharply. The Dow Jones industrial average fell more than 100 points, before recovering somewhat as Wall Street analysts quickly assured investors that the central bank head was saying nothing much new from testimony earlier this month and in December.

"I don't think there is any new substance in this report," said Steven Ricchiuto, an economist with Dean Witter Reynolds Inc., New York, after reading Mr. Greenspan's written testimony. "The tone is worse than the actual substance."

Mr. Gramley, however, predicts that if investors continue to drive up prices, the Fed will first raise the margin required when shareowners buy stock on credit. Then, if the market doesn't cool, he expects the policymaking body of the Fed, the Open Market Committee, to raise interest rates. The first regular opportunity to do so will come when that body next meets March 25.

What concerns Gramley is that stock prices will rise so much that this distortion will put the economy itself at risk. He notes how Greenspan, in his testimony to Congress Dec. 5 with his now-famous question about whether "irrational exuberance" was driving the market, pointed to Japan's economy, which remains troubled five years after its stock-market bubble burst.

What did seem new in the Greenspan testimony yesterday, according to Nick Lau, an economist with Brown Brothers Harriman & Co., were some comments on the possibility that corporate profits were over-estimated.

"He was a little more specific this time," Mr. Lau says.

As in earlier testimony, Greenspan said he could not rule out a preemptive increase in interest rates to hold economic growth and prices in check. The stock market runup could help feed inflation, he said, despite a Fed forecast that inflation would remain at or under 3 percent this year.

On the stock market, he noted: "History demonstrates that participants in financial markets are susceptible to waves of optimism. Excessive optimism sows the seeds of its own reversal in the form of imbalances that tend to grow over time."

There may be reasons - global competition, new information technology - to believe something is "fundamentally new" about current stock market conditions, he added.

But "History is strewn with visions of such 'new eras' that, in the end, have proven to be a mirage. In short, history counsels caution. Such caution may be especially warranted with regard to the sharp rise in equity prices during the past two years."

In its forecast for 1997, the Fed predicted real economic growth of between 2 and 2.25 percent. The Fed also predicts inflation of 2.75 to 3 percent and an unemployment rate of about 5.25 percent - both similar to 1996.

Greenspan listed the factors he believes have kept inflation unusually low: job insecurity restraining wage growth, intense global competition, a strong dollar keeping import prices down, and wide profit margins that give firms room to accommodate increased costs without raising retail prices. But all of those factors may be temporary. "We cannot rule out a situation in which a preemptive policy tightening may become appropriate before any sign of actual higher inflation becomes evident," he said.