In his semi-annual Monetary Policy Report to Congress today, U.S. Federal Reserve Board chairman Alan Greenspan said that interest rates would need to rise further to keep inflation in check.

In addition to higher rates, he projected sustained economic growth and muted inflation. This message was more or less what markets were expecting to hear. Bank of Montreal says, “His upbeat assessment of the economy supported the U.S. dollar and weighed on bond markets.” BMO adds that Greenspan’s comments are in line with its view that the fed funds rate will likely climb from 3.25% currently to 3.75% over the next two policy meetings in August and September.

This call is echoed by BMO’s colleagues at BMO Nesbitt Burns. They are also calling for two more rate hikes this year, bringing the fed funds rate to 3.75%. “Whether the Fed tightens further next year will depend critically on oil prices and long-term interest rates,” Nesbitt says. “Higher oil prices and higher long-bond yields reduce the chance of further Fed tightening, even though higher oil prices might increase inflation pressure. If oil prices rise, but long-term interest rates remain at roughly current levels, expect the Fed to tighten further next year. Our bet is that bond yields rise moderately, forestalling the need for significant further Fed tightening in 2006.”

BMO observes that Greenspan allowed that ‘significant uncertainties’ that could alter the Fed’s course of action. “On the upside for interest rates, the outlook for inflation could deteriorate if productivity growth continues to slow and unit labour costs accelerate. On the downside, rising energy prices could dampen economic growth more than anticipated,” it says.

“Current low long-term interest rates pose two-sided risks,” it adds. “If sustained, they could spur too-strong growth and higher inflation, requiring more aggressive monetary tightening. Conversely, they could pump-up some local housing markets where ‘prices seem to have risen to unsustainable levels’ even more, eventually causing home prices to collapse and some regional economies to weaken.”

BMO Nesbitt notes that Greenspan remains stumped by the persistence of low long-term interest rates. “Given the backdrop of firm U.S. economic growth, Federal Reserve tightening, continued high oil prices, and large federal financing needs, Greenspan is puzzled why long-term interest rates aren’t higher,” it says.

“Long-term interest rates have fallen all over the world, as yield curves have flattened, especially in the U.S. The Fed Chairman attributes this global phenomenon to a secular decline in inflation, reduced inflation and business-cycle volatility and, thus, the ensuing decline in risk premiums,” it notes. And, it points out that, once again, he commented that “the break up of the Soviet Union and the integration of China and India into the global market economy has increased productive capacity and competition, thereby reducing pricing power and inflation”.

“He also made some very controversial statements along the lines of former Fed Governor Bernanke’s theory that global intended savings flows are in excess of global intended investment demand, creating an excess supply of capital and, therefore, lower long-term interest rates,” BMO Nesbitt observes.

Bernanke is now the head of the President’s Council of Economic Advisors and is on every short list of rumoured potential Greenspan replacements, it notes. Greenspan’s term ends in January. This theory of excessive savings in emerging and oil-producing economies is highly contentious. “Greenspan spilled a good deal of ink explaining and justifying these claims, and did suggest that investment prospects are now improving in both the U.S and Japan,” it says.

BMO Nesbitt also notes that Greenspan warned that recent reduced volatility in economic growth cycles and in financial asset prices has led to an imprudent expectation of continued stability reflected in reduced credit risk premiums. It predicts that a quotable line from his text will be, “History cautions that long periods of relative stability often engender unrealistic expectations of its permanence and, at times, may lead to financial excess and economic stress.” Adding that he goes on to suggest that the perception of lower risk, as well as the low level of long-term yields, is contributing to the housing boom.

“Greenspan completed his sermon with a lecture on the need for continued free trade and the dangers of trade restrictions and unnecessary regulation,” it concludes.