The Hindu Business Line : Markets fixed on Greenspan testimony

THE high point for markets this week is not the plethora of US data - retail sales, capital flows, industrial production, PPI or consumer confidence - but the Federal Reserve Chief, Mr Alan Greenspan's testimony to Congress. This big event is billed for Wednesday.

The Federal Reserve has ratcheted up interest rates from one per cent to 2.5 per cent in steps of 25 basis points at every meeting from June 2004. It will continue to raise till a neutral level is reached.

But what is the neutral level? Ah, we don't know till we get there! Such is the message dinned in by the Fed and its Governors, time after time.

They have also not deviated from their stance of "removing policy accommodation at a measured pace". Consistency and transparency have been their virtue. Even as the short-term rates have been hiked, peculiarly, bond yields have moved in the opposite direction. From close to five per cent, 10-year Treasuries now offer barely a sliver over four per cent.

On more than one occasion last year, they dropped well below this level. What's going on?

Have investors become supremely confident that inflation is a ghost of the past and in the Fed's ability to put it down quickly if at all it surfaces? That bond yields have tanked despite surging energy and commodity prices is a puzzle. The result is a practically flat yield curve with the spread between 10 years and two years at just 75 basis points.

Meanwhile, what is going to be the thrust of the Greenspan testimony? Will we have a preview of a change in Fed policy? That looks unlikely given that there has been no change in the US economic landscape since the last Fed meeting. The tricky issues for Mr Greenspan are the twin deficits on Budget and trade. On the latter, he has taken conflicting positions.

In a November 2004 speech, he spoke about its unsustainability while on the eve of the G-7 conference about 10 days back, he was confident of market forces ensuring a non-disruptive adjustment, that is, without sharp dollar or interest rate moves.

Mr Greenspan's remarks on the spiralling fiscal red ink and its implications for interest rates will also be keenly watched.

A question and answer session will probably follow the testimony where the potential for some market-shaking comments are significant. Overall, market risk lies in his views on the deficits. His words may not be all that soothing for markets. A rise in yields and a fall in the dollar are likely post-Greenspan's testimony.

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