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Fed chairman's rates warning shakes markets world-wide

Alan Greenspan went out of his way yesterday to remind US financial markets that the boom cannot last. The Fed Chairman's unexpected remarks shook Wall Street, where they were read as an early warning of higher interest rates.

Diane Coyle and David Usborne report on a day of pandemonium in the financial markets.

As a reaction to a statement of the obvious, it was dramatic. The Dow Jones index plunged 115 points to 8,062, a 2 per cent fall, and the benchmark long-term Treasury bond shed almost 2 full points in price within minutes of testimony by the Federal Reserve Chairman yesterday.

Wall Street regained some of its poise later, closing 83 points down at 8095.1. But Mr Greenspan rattled the financial markets world-wide as he repeated his fears that the continuing optimism about the US economy may be gravely overstated.

In London the FTSE 100 index ended nearly 44 points lower at 5,262.1, and gilts fell sharply. Nerves were already slightly frayed as traders waited for the Bank of England's decision on interest rates, due at noon today, even though most analysts expect no change.

Mr Greenspan, speaking before a committee of the House of Representatives yesterday, said the US economy had been on an "unsustainable track". He also warned that it would be "unrealistic" to expect the stock market to carry on climbing at its recent pace.

The remarks were taken as a fresh warning that Mr Greenspan may soon increase interest rates to prick what he views as a dangerous financial bubble, marked by the climbing equity market.

With the tenth anniversary of the 19 October 1987 crash, when Wall Street fell 23 per cent in a single day, looming ominously, Mr Greenspan focused on the increasingly tight US jobs market. He expressed the fear that an unemployment rate below 5 per cent must inevitably lead at some point to wage pressures that would fuel inflation.

"There would seem to be emerging constraints on potential labour input," he said. "If the recent 2 million plus annual pace of job creation were to continue, the pressures on wages ... could escalate more rapidly." And echoing comments he made last December about "irrational exuberance" on Wall Street, Mr Greenspan again suggested that the pace of growth in stock prices will not be sustainable.

"It clearly would be unrealistic to look for a continuation of stock market gains of anything like the magnitude of those recorded in the past couple of years," Mr Greenspan said.

"In equity markets, continual upward revisions of long-term corporate earnings expectations have driven price-earnings ratios to levels not often observed at this stage of an economic expansion."

The shock of his testimony was all the greater because it had been billed as a general overview of the economy with little news value. While Mr Greenspan may be hoping that his comments alone may help to cool some of the ardour for stocks, many economists took them as a clear warning that at its next meeting, the Fed might feel obliged to raise rates.

"He has gone out of his way deliberately to give the markets a fright," said Ian Shepherdson of HSBC Markets in New York.

"He is ready to put his money where his mouth is," suggested David Jones of Aubrey Langston. "He is ready to tighten money conditions and I think that is the essential change we are seeing today."

The Fed has not altered monetary policy since it raised US rates marginally last March. Since then, however, the momentum in economic growth and market escalation has shown no signs of fading.

The unemployment rate, for example, has remained at levels lower than at any time in the past 25 years. Mr Greenspan said there were not enough working-age people in America to meet demand for labour at the current pace. "The law of supply and demand has not been repealed."

The Fed chairman acknowledged that, as yet, there have been no signs of any pick-up in inflation or indeed in wage costs. The latter, he said, was in part because of the effect of the strengthened exchange rate of the dollar as well as a continuing unwillingness in the workforce to demand wage increases because of lingering insecurity about jobs.

"The force insecurity may be fading," the chairman said, however. "A re-emergence of inflation is, without, question, the greatest threat to sustaining what has been a balanced economic expansion virtually without parallel in recent decades."

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