MR Alan Greenspan, the chairman of the Federal Reserve, yesterday sent another strong signal to financial markets that the US central bank was increasingly concerned about the impact on the economy of the continuing surge in equity prices.
In his semi annual Humphrey Hawkins testimony to the US Senate on the conduct of the Fed's monetary policy, Mr Greenspan said "excessive optimism" could trigger asset price inflation in US financial markets and again asked rhetorically if the Federal Reserve would be able to detect "irrational exuberance" in US equity trading.
Mr Greenspan hinted that a move by the Fed to tighten credit might be needed even before inflationary pressures became acute:
"We cannot rule out a situation in which a pre emptive policy tightening may become appropriate before any sign of actual, higher inflation becomes evident," Mr Greenspan said.
The hawkish comments from Mr Greenspan had an immediate impact on bond markets, and in Dublin gilt prices fell across the range of maturities.
The longer end of the market felt the worst of the negative sentiment with long gilts dealing down over 50p to close on yields of 6.60 per cent, while losses were more modest at the shorter end of the market.
The reaction on stock markets was more sanguine, with dealers now treating a 100 point fall by the Dow as a commonplace event. Most markets closed lower on the day, but the losses were relatively insignificant.
The dollar was sharply higher against most European currencies, with the result that the pound once again soared to a new high within the European Monetary System. By the close in Dublin, the pound was trading over 11.5 per cent higher against the weakest ERM currency, the French franc, the highest the pound has reached on the ERM grid in the past few weeks.
If the dollar maintains or increases its strength - it gained over 50 cents against the pound yesterday to close on $1.5830 - it will probably put increased upward pressure on the pound within the ERM and increase speculation that Irish interest rates will fall over the coming months.
This was the second time in the last six months that Mr Greenspan has destabilised stock and bond markets. Last December he raised the same question: "History demonstrates that participants in financial markets are susceptible to waves of optimism, which can in turn foster a general process of asset price inflation that can feed through into markets for goods and services," he said.
He acknowledged that Federal Reserve analysts "have not been able, as yet, to provide a satisfying answer" to when markets begin to behave irrationally. "But there are reasons in the current environment to keep this question on the table," he said.
While inflation "has remained quiescent" since July, he said "the trend in inflation rates in the core Consumer Price Index and in broader price measures may be somewhat less favourable than in recent years."
Mr Greenspan said the committee continued to see "inflation risks on the upside and must remain alert to the possible emergence of imbalances in financial and product markets".
