Fed points to higher interest rates: Greenspan says action may be needed on inflation. Diane Coyle reports

THE chairman of the Federal Reserve, Alan Greenspan, yesterday warned that rapid growth meant the US economy was running into bottlenecks. In his twice-yearly Humphrey-Hawkins testimony before Congress, Mr Greenspan indicated that the Fed could soon raise interest rates to head off higher inflation.

In prepared testimony to the Senate Banking Committee, Mr Greenspan said: 'It is an open question whether our actions to date have been sufficient to head off inflationary pressures and thus maintain favourable trends in the economy.'

Bond dealers reacted to the unexpectedly pessimistic assessment of inflation prospects with a sharp sell-off of US Treasury bonds, which initially helped take the dollar lower against other currencies. It closed down slightly in London at DM1.5615 and 98.55 yen, but recovered later in New York as dealers registered the prospect of an interest-rate rise.

In one of his strongest recent statements about the dollar, Mr Greenspan said its weakness during the past few months would put upward pressure on prices if it were not reversed soon. Faster increases in commodity prices and raw materials costs were giving additional cause for concern.

The Fed chairman said economic growth was 'appreciably' above its long-term trend. The Federal Reserve forecast GDP growth of 3-3.25 per cent this year and 2.5-2.75 per cent in 1995. It predicted consumer prices would rise 2.75-3 per cent this year, and 2.75-3.5 per cent next year.

Adrian Cunningham, an economist at UBS, said: 'He spooked the markets. They had expected a far more neutral testimony.' Mr Greenspan's remarks about the dollar were read as a clear signal that the Fed was taking its prolonged decline seriously.

Traders thought international investors expected more instability in the financial markets as a result of the testimony and would continue to shun US bonds because of expected currency losses. Since early this year, Japanese investors have been selling holdings of US assets.

Steven Hannah, chief economist at IBJ International, said: 'Japanese investors would need much higher yields, much less volatility and a clear resolution of the US-Japan trade dispute.' Some observers believe the US has been pursuing an exchange-rate policy of benign neglect as a means of reducing the trade deficit with Japan.

Lloyd Bentsen, the US Treasury Secretary, reacted to Mr Greenspan's comments by saying they shared the same objectives of long- term growth and low inflation. 'I am quite pleased with the economy,' he said.

Mr Greenspan yesterday made it clear that the member Federal Reserve governors want to do more to bring inflation down. 'Our nation has made considerable progress in putting the economy on a sound footing in the past few years. To preserve and extend these advances, our monetary and fiscal policies will need to remain disciplined.'

The Federal Reserve is now expected to raise interest rates around 16 August, the date for the next meeting of the Federal Open Market Committee.

Between now and then the nervy financial markets face several hurdles. The official figure for second-quarter GDP growth will be published tomorrow. It is expected to confirm the Fed chairman's assessment that the economy has expanded rapidly - even though figures published yesterday showed housebuilding had slumped in June. The annual rate of new house starts fell 9.8 per cent in the month to 1.35 million units.

Next week brings potential political upsets due to further trade talks with Japan and the beginning of congressional hearings on the Whitewater affair.