Federal Reserve Board chairman Alan Greenspan indicated Tuesday that the Fed is prepared to lower U.S. interest rates further if necessary.

Greenspan presented his semiannual monetary policy report to the U.S. Congress before the Committee on Banking, Housing, and Urban Affairs.

Greenspan suggested that interest rates may remain low for some time. “The Federal Open Market Committee stands prepared to maintain a highly accommodative stance of policy for as long as needed to promote satisfactory economic performance. In the judgment of the Committee, policy accommodation aimed at raising the growth of output, boosting the utilization of resources, and warding off unwelcome disinflation can be maintained for a considerable period without ultimately stoking inflationary pressures,” he said.

While he suggested that forward-looking economic indicators are mostly positive, Greenspan also allowed that “downside risks to the business outlook are also apparent, including the partial rebound in energy costs and some recent signs that aggregate demand may be flagging among some of our important trading partners.” He noted that both oil and natural gas price rises are worrisome.

Greenspan reiterated the Fed’s worries about deflation, notably that it becomes much harder to accommodate negative shocks in a low inflation environment. He suggested that there are important lessons to be learned from Japan’s deflation experience, “and it is incumbent on a central bank to anticipate any contingency, however remote, if significant economic costs could be associated with that contingency,” he said.

He also reported that the Fed has been studying how to provide policy stimulus should “our primary tool of adjusting the target federal funds rate no longer be available.” In other words, should rates go to zero. “However, given the now highly stimulative stance of monetary and fiscal policy and well-anchored inflation expectations, the Committee concluded that economic fundamentals are such that situations requiring special policy actions are most unlikely to arise. Furthermore, with the target funds rate at 1%, substantial further conventional easings could be implemented if the FOMC judged such policy actions warranted.”

Greenspan acknowledged that some financial firms would experience difficulties if rates went to zero, “but these intermediaries have exhibited considerable flexibility in the past to changing circumstances. More broadly, as I indicated earlier, the FOMC stands ready to maintain a highly accommodative stance of policy for as long as it takes to achieve a return to satisfactory economic performance,” he concluded.

Economists were cheered when Greenspan suggested the Fed would not be taking special actions to boost the money supply, but this revelation whacked bond markets.

Bank of Montreal says that Greenspan, “provided an optimistic assessment of the economy’s prospects, while at the same time underscoring that the Fed will hold rates down “for as long as it takes” to achieve a strong, sustainable recovery.” RBC Financial points out that the Fed expects the economy expected to grow by between 3.75% to 4.75% from the fourth quarter of 2003 to the fourth quarter of 2004.

BMO Nesbitt Burns chief economist, Sherry Cooper, says that Greenspan’s testimony was “a bombshell for bonds”. She notes that he essentially ruled out the possibility of using “special policy actions” to ease monetary policy in the future. “In the immediate aftermath of these remarks, 10-year yields jumped more than 10 basis points,” she reports.

“Overall, we share the Fed’s view that a meaningful recovery will emerge, given the amount of stimulus that is being piped into the economy,” offers RBC Financial. “Nevertheless uncertainties still abound, and while the risks of deflation remain very slim, we expect the Fed funds rate to remain low for an extended period of time, with some risk that the Fed could cut further if need be.”