By Gregory Robb, CBS Marketwatch.com
July 20, 2004

WASHINGTON (CBS.MW) -- The Federal Reserve intends to stay on the path toward higher interest rates after taking its first step only last month, Federal Reserve Chairman Alan Greenspan said Tuesday.

There are greater risks to the economy from the current low rate environment than from a transition to higher rates, Greenspan told the Senate Banking Committee in his first of two days of testimony to Congress on the Fed's current monetary policy.

The Fed chairman dismissed signs of weakening consumer spending in June as "short-lived."

He said the Fed believed that the recent pickup in inflation was largely due to transitory factors, but cautioned that the central bank was still worried that "there are not more deep-seated forces emerging" to boost inflation as a result of such low interest rates.

"Accordingly, in assessing the appropriateness of the stance of policy, the Federal Reserve will pay close attention to incoming data, especially costs and prices," he said.

The Fed decided on June 30 to raise short-term interest rates to 1.25 percent from 1.0 percent. That was the first tightening in four years. In the statement, the FOMC said that future rate hikes were needed at a measured pace.

Wall Street economists have essentially translated the statement to mean that the Fed will continue raising rates this year by 25 basis points at three of the next four meetings left this year, putting the federal funds rate at 2 percent by year-end.

Greenspan laid out two paths for interest rates -- a measured pace or a "less gradual" approach.

Greenspan said that if rate hikes can proceed at a measured pace, "a relatively smooth adjustment of businesses and households to a more typical level of interest rates seems likely."

But the economy appears strong enough to handle a less-than-gradual monetary policy adjustment, he said.

"Even if economic developments dictate that the stance of policy must be adjusted in a less gradual manner to ensure price stability, our economy appears to have prepared itself for a more dynamic adjustment of interest rates," Greenspan said.

There are risks of higher interest rates, but these were outweighed by leaving rates low as the economy improves.

"Some risks necessarily attend this transition (to higher rates) but they are outweighed in our judgment by those that would be associated with maintaining the existing degree of monetary policy accommodation in the current environment," Greenspan said.

Some economists have expressed concern about the sharp decline in auto sales and overall retail sales in June.

But Greenspan assured the Senate panel that "the expansion is self-sustaining."

Higher oil prices "by eroding households' disposable income, have accounted for at least some of the observed softness in consumer spending of late, a softness which should prove short-lived," he said.

"Despite the softness in recent retail sales, the combination of higher current and anticipated future income, strengthened balance sheets and still-low interest rates bodes well for consumer spending," he said.

Some of the strength in the economy is contributing to a rise in inflation this year, Greenspan said.

"But inflation also seems to have been boosted by transitory factors such as the surge in energy prices," he said.

Overall, a "benign environment" remains on inflation. Unit labor costs are not threatening price stability and the economy is not operating at its productive capacity, which should contain cost pressures, he said.

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