WASHINGTON - Federal Reserve Chairman Alan Greenspan roiled financial markets yesterday by declaring that the threat of deflation is "no longer an issue" and that the economy seems to be strengthening on many fronts.
Greenspan's brief but buoyant comments about the economy, during testimony at a Senate hearing, sent shivers through the stock and bond markets, as investors interpreted his words as additional evidence that the Federal Reserve will raise interest rates before the end of the year.
Treasury prices tumbled after Greenspan's comments, driving up their yields, which move in the opposite direction. The yield on the 10-year note, a benchmark for many consumer borrowing rates, rose to its highest closing for the year, 4.46 percent, up from 4.39 percent Monday.
The major stock indexes were all down more than 1 percent. And in currency markets, the dollar rose to its highest level against the euro in five months, on the prospect of higher U.S. interest rates.
Testifying before the Senate banking committee, Greenspan said he agreed with predictions of many private economists that the job market is recovering and that economic growth is improving.
More significant, Greenspan said lingering worries about the risks of a Japanese-style deflation had essentially disappeared. Worries about such an economic stagnation, characterized by prices falling below profitable levels, were one reason that the central bank reduced the federal funds rate on overnight loans to 1 percent, its lowest level in 58 years.
The central bank kept rates down even after the economy picked up momentum last summer.
"It is fairly apparent that pricing power is gradually being restored," Greenspan said, in response to question from Sen. Richard C. Shelby, the Alabama Republican who chairs the banking committee. "Threats of deflation that were a significant concern last year by all indications are no longer an issue before us."
The hearing, although devoted primarily to bank regulation, provided an opportunity for Greenspan's first public comments about the economy since the release of data this month that showed job creation and inflation were unexpectedly high last month.
Fed officials have made it clear for months that they would eventually have to raise interest rates, but the central bank has also said it could afford to be "patient" and wanted to see more solid evidence of a job recovery and greater ability of companies to raise their prices.
To the apparent disappointment of investors, Greenspan paid no lip service yesterday to the idea of being "patient" and said the economy appears to have undergone a change in "the last number of weeks."
The Fed chairman also told lawmakers that banks are generally well-positioned to manage an increase in interest rates. "The industry appears to have been sufficiently mindful of interest rate cycles and to have exposed itself to undue risks," he said.
Bond investors, increasingly convinced lately that the Fed will retreat from its policy of cheap money as early as summer, have been driving up rates on longer term Treasury bonds for the past month. As recently as last month, the 10-year yield was as low as 3.68 percent, more than three-quarters of a percentage point below yesterday's close.
Mortgage rates have edged up about a half of a percentage point in the past month, with the average rate on a 30-year fixed-rate mortgage up to 5.97 percent, according to Bankrate.com.
"The market was caught off-guard" by Greenspan's comments, said Lou Crandall, chief economist at Wrightson ICAP, a bond-market research firm in New York. "There had been some hope in the market that Greenspan would suggest the sell-off in Treasuries had been overdone. Instead, he chose to say that things had changed in the past few weeks. He just snatched away the hope that he was going to be more friendly."
Fed officials have also suggested that they are not likely to start tightening policy as early as May 4, the next meeting of the Federal Open Market Committee, which sets interest rates.
Roger Ferguson, vice chairman of the Federal Reserve Board, noted in a speech last month that it remained unclear whether the surprisingly strong job growth last month, with 308,000 additional jobs, was the start of a turnaround in the labor market.
And even though Greenspan said the specter of deflation had been put to rest, he also showed little concern that inflation is a threat.
In response to questions yesterday, the Fed chairman repeated his view that the sharp rise in commodity prices during the past year is unlikely to be a serious indicator of inflation.
But Greenspan also pegged his optimism about inflation to the continued growth of productivity.
The big question now is whether the central bank will raise rates this summer, before the presidential elections, or wait until next year. Greenspan might provide additional guidance on that issue today, when he is to testify before the House-Senate Joint Economic Committee.