The Fed chief told the House Financial Services Committee that, despite high energy costs and other concerns, economic growth is on a "firm footing" while inflation remains in check. But the central bank will continue to raise short-term interest rates to keep things that way, he said.
"Our baseline outlook for the U.S. economy is one of sustained economic growth and contained inflation pressures," the 79-year-old Greenspan told the committee in one of his last appearances before Congress as Federal Reserve chairman.
Recent economic reports have shown that consumer spending is resilient, despite high gasoline prices. Business spending is picking up. Manufacturing is rebounding. Corporate profits continue to beat expectations. But inflation remains relatively tame, and while job creation is gaining momentum, there still is slack in the labor market with many people out of the work force.
Such conditions, some analysts say, are re-enacting the "Goldilocks" economy of the late 1990s - not too hot, not too cold. That perception has been a key catalyst behind the stock market's rally in recent weeks, analysts say.
But to sustain economic growth and contain inflation, Greenspan said, the central bank must "continue to remove monetary accommodation" - Fed-speak for raising interest rates to a neutral level that retards inflation and economic growth.
Greenspan and many economists are concerned about two key inflation bugaboos: rising labor costs and energy prices. While rising wages are great for workers, it's not so great if you're the nation's No. 1 inflation fighter.
A solidly growing economy will push wages higher, forcing businesses to raise prices, said Ken Goldstein, an economist at the Conference Board, a business research organization in New York.
Average hourly wages rose 2.7 percent on an annualized basis in June, up from around 2 percent in January 2004, but will reach 4 percent by the end of next year or early 2007, Goldstein said.
"For employers to get good talent, they are going to have to pay for it," he said. Because of that, "inflation is going to edge higher, therefore short-term interest rates must go higher."
The Fed revealed yesterday that it raised its forecast for inflation. The central bank expects a key inflation gauge - which excludes food and energy costs - to rise to between 1.75 percent and 2 percent this year, up from the forecast made in February of 1.5 percent to 1.75 percent. The measure stood at 2 percent in the first quarter.
The Federal Reserve also cut its forecast for economic growth to 3.5 percent this year, down from the previous estimate of between 3.75 percent and 4 percent. The economy grew at a 3.8 percent rate in this year's first quarter.
Greenspan also reiterated his concern about low long-term interest rates, which have stayed down despite the Fed's increases in short-term rates.
That situation, which he has called a "conundrum," has depressed mortgage rates, helping to create what he called "froth" in the housing market.
The unexpected decline in mortgage and other long-term rates "has stimulated activity even as the Fed has increased short rates. Result: Short [term] rates have to keep rising," said Ian Shepherdson, chief U.S. economist for High Frequency Economics in Valhalla, N.Y.
The Fed's benchmark federal funds rate now stands at 3.25 percent, up from a generational low of 1 percent in June 2004.
Many economists and investors expect that rate to hit 4 percent by year's end, meaning that the Fed will apply quarter-point increases at three of its four remaining meetings. Its next gathering is Aug. 9.
Greenspan will appear today before the Senate Banking Committee in his last scheduled semiannual congressional testimony before his Fed term ends in January.
The Los Angeles Times is a Tribune Publishing newspaper.