Federal Reserve (search) Chairman Alan Greenspan (search) on Tuesday said the U.S. economy has entered a sustainable expansion that should weather a June slowdown and is under no serious threat from inflation.

The Fed chief told the Senate Banking Committee (search) faster growth was creating price pressures but some of them, like energy costs, were temporary, so interest rates likely can rise to an unspecified "neutral" level at a "measured" pace.

"Those higher prices, by eroding households' disposable income, have accounted for at least some of the observed softness in consumer spending of late, a softness which should prove short-lived," Greenspan said in his semiannual testimony on monetary policy.

In answering lawmaker questions, the Fed chief said the economy had shown improvement already in July, particularly in auto sales.

"There is no real underlying evidence of any cumulative weakness here. It is nonetheless the case that the little bulge in inflationary pressures seems to have created a soft patch here and it is something obviously we are watching very closely," he said.

While saying rising prices did not pose a major risk right now, Greenspan warned that policy-makers couldn't be sure inflation would stay benign indefinitely given still-low interest rates.

Greenspan told lawmakers the Fed has deliberately avoided spelling out what it means by "measured" rate rises, though financial market participants take the word as a prescription for modest quarter percentage point moves.

He said the Fed's benchmark fed funds rate needs to rise to a level that is considered neutral — enough to curb inflation without depressing growth — but conceded he did not know what that level was.

"Actually, we don't know what neutrality is until we get there," he said when pressed to define the term. "You can tell whether you're below or above, but until you're there, you're not quite sure you are there."

Greenspan's overall message on the economy with just a few months left before the presidential elections was upbeat.

"Not only has economic activity quickened, but the expansion has become more broad-based and has produced notable gains in employment," he said.

Analysts read it that way and stock prices rose as the Fed chief — whose testimony attracts intense focus around the globe — began speaking. Bond prices fell, though, as investors interpreted his optimistic remarks as a likely indicator of further interest-rate hikes.

Markets See Rate Rises

"It looks like Mr. Greenspan is saying the slowdown in the economy will be short-lived and that suggests that the Fed will probably continue to raise rates," said Gary Thayer, chief economist at A.G. Edwards & Sons in St. Louis.

Greenspan also presented the Fed's latest forecasts for growth, employment and inflation this year and next.

The Fed expects real economic growth at 4.5 percent to 4.75 percent versus a forecast in February for growth of 4.5 percent to 5.0 percent.

The central bank said so-called core inflation, which excludes energy and food costs, as measured by the Commerce Department's (search) personal consumption expenditures index, should rise by a relatively mild 1.75 percent to 2.0 percent.

However, Greenspan said faster job creation was bolstering incomes and consumer spending — notwithstanding a June lull when retail sales weakened — and this in turn added some inflation pressure.

"The evident strengthening in demand that underlies this improved performance doubtless has been a factor contributing to the rise in inflation this year," he said. "But inflation also seems to have been boosted by transitory factors such as the surge in energy prices."

Recent price increases appeared in many cases to be caused by businesses attempting to raise profit margins rather than increased production costs, Greenspan added.

Wages No Threat 

"For the moment, the modest upward path of unit labor costs does not appear to threaten longer-term price stability, especially if current exceptionally high profit margins begin to come under more intense competitive pressures at home and from abroad," Greenspan said.

"But we cannot be certain that this benign environment will persist and that there are not more deep-seated forces emerging as a consequence of prolonged monetary accommodation," he added.

The Fed cut short-term interest rates (search) to a 1958 low of 1 percent by mid-2003 after a 13-step process that began in 2001. At its last policy session on June 29-30, it began reversing course by lifting its official federal funds rate a quarter percentage point.

More rate rises are expected later this year, though analysts are divided about how fast they will climb. Greenspan said policy-makers will keep a close eye on costs and prices as it weighs whether a faster-operating economy generates more cost pressures.