“Federal Reserve Chairman Alan Greenspan grabbed headlines last week for his opinions on a variety of big-picture issues, from Social Security and tax cuts to budget deficits and the regulation of housing giants Fannie Mae and Freddie Mac,” writes Aaron Lucchetti in today’s Wall Street Journal.

“But many investors are more concerned with the central bank’s bread-and-butter issue — setting the path for short-term interest rates.”

“Stock and bond markets right now ‘hinge on inflation fear’ and whether the Fed and bond traders will go into ‘tightening mode,’ meaning rate increases, says James Paulsen, chief investment strategist at Wells Capital Management. Stocks should continue to rise through 2004, but only if bond yields and short-term interest rates stay stable, he says.”

“Interest rates influence stock prices because they affect the cost of corporate borrowing — and therefore corporate profits. If rates go up, the cost of borrowing from both banks and bond investors rises. Investors also use rates to help them calculate the present value of a company’s future earnings and cash flows. Higher rates make newly issued bonds more attractive to investors, who may switch out of stocks to buy them.”

“In recent weeks, investors have actually grown less concerned about a spike in short-term interest rates. Traders of federal-funds futures contracts expect a 25% chance of a rate increase by July, down from the 65% chance foreseen a month ago. ‘The widely anticipated rate hike will occur later rather than sooner,’ says John Lonski, chief economist at Moody’s Investors Service.”

“Analysts say the Fed won’t raise rates until job growth picks up more. Bond traders agree and have sent Treasury yields lower after a bout of indigestion last summer.”

“That kind of complacency worries Mr. Paulsen. He says that the declining bond yields and skepticism about inflation and job growth set up a scenario in which one or two surprisingly strong economic reports could spook the bond market, forcing 10-year Treasury yields to about 5% from their current level just under 4%.”

“That kind of jolt could raise costs for businesses as well as homeowners, possibly wiping out potential gains in the stock market in the process. Stocks are ‘probably going up until you get an inflation scare,’ says Mr. Paulsen. If the economy keeps growing at 4% and there’s no inflation, they ‘will go up quite a bit.’ But inflation and rising interest rates would likely offset strong corporate earnings growth, keeping the stock market near current levels, he says.”

“Last week, the Dow Jones Industrial Average slipped for the second-consecutive week, despite rising 3.78 points, or 0.04%, Friday to close at 10583.92. The Nasdaq Composite Index lost ground for the sixth straight week and ended 5.8% off its January high. The index finished Friday at 2029.82, down 0.4% for the week. Despite the drops, the Dow, Nasdaq and other major stock indexes remain in the black for the year.”