Greenspan defends Fed's record over market failing

The chairman of the US central bank said suggestions that he should have raised interest rates to deflate rising stock prices in the late 1990s were misplaced.

"The notion that a well-timed incremental tightening could have been calibrated to prevent the late 1990s bubble is almost surely an illusion," he told the annual monetary policy symposium of the Federal Reserve Bank of Kansas City in Jackson Hole.

With most stock price indices still languishing more than 25 per cent below their peak, and with the US economy still suffering the effects of the collapse of the 1990s bubble, Mr Greenspan offered his most comprehensive defence yet of Fed policy in the period.

He gave examples of how previous periods of sharp increases in interest rates - in 1988-9 and in 1994-5 - had failed to stop equity prices rising. The experience suggested it was impossible to burst a bubble without inducing a recession - "the very outcome we would be seeking to avoid."

The Fed chairman said other measures to restrain inventor enthusiasm such as tougher margin requirements or verbal warnings from officials would not have worked, and added that it was in any case not possible for policymakers to say with certainty when asset prices had reached unsustainable levels.

"As events evolved, we recognised that, despite our deep suspicions, it was very difficult to definitively identify a bubble until after the fact - that is, when its bursting confirmed its existence."

Perhaps more than any single policymaker Mr Greenspan became personally associated with optimism about US economic performance in the late 1990s, repeatedly expressing confidence that rising productivity growth had lifted the economy onto a path of stronger growth.

Despite his warning about the dangers of "irrational exuberance in financial markets in 1996, the Fed's policymakers declined to raise interest rates or take other measures to prevent the surge in asset prices.

The Fed did eventually raise short-term interest rates - to guard against inflationary pressures in the broader economy - by 175 basis points in 1999 and 2000, but critics have said that was too little, too late.

Mr Greenspan repeated his belief that accelerated productivity growth - clearly evident still in the official data, despite the slowdown of the last two years - had lifted the profitability of US companies. And he said the decreased volatility of US economic performance in the last 20 years had lowered the equity risk premium - the extra return investors demand from equities compared with bonds to protect them from the greater volatility of stock prices.

But he said investors, as they had in the past, had developed unrealistic expectations about continued profits growth - and had raised valuations of equities beyond what could reasonably be justified.

But Mr Greenspan did not dismiss the idea that there could be new ways for central banks to address bubbles, and called for further research on the issue.