"The Federal Reserve will be weighing these influences as it endeavors to help extend the current

period of sustained growth. Participants in financial markets seem to believe that in the current benign

environment the FOMC will succeed indefinitely. There is no evidence, however, that the business

cycle has been repealed. Another recession will doubtless occur some day owing to circumstances that

could not be, or at least were not, perceived by policymakers and financial market participants alike.

History demonstrates that participants in financial markets are susceptible to waves of optimism,

which can in turn foster a general process of asset-price inflation that can feed through into markets

for goods and services. Excessive optimism sows the seeds of its own reversal in the form of

imbalances that tend to grow over time. When unwarranted expectations ultimately are not realized,

the unwinding of these financial excesses can act to amplify a downturn in economic activity, much as

they can amplify the upswing. As you know, last December I put the question this way: "...how do

we know when irrational exuberance has unduly escalated asset values, which then become subject to

unexpected and prolonged contractions ...?"

We have not been able, as yet, to provide a satisfying answer to this question, but there are reasons in

the current environment to keep this question on the table. Clearly, when people are exposed to long

periods of relative economic tranquility, they seem inevitably prone to complacency about the future.

This is understandable. We have had fifteen years of economic expansion interrupted by only one

recession--and that was six years ago. As the memory of such past events fades, it naturally seems

ever less sensible to keep up one's guard against an adverse event in the future. Thus, it should come

as no surprise that, after such a long period of balanced expansion, risk premiums for advancing

funds to businesses in virtually all financial markets have declined to near- record lows.

Is it possible that there is something fundamentally new about this current period that would warrant

such complacency? Yes, it is possible. Markets may have become more efficient, competition is more

global, and information technology has doubtless enhanced the stability of business operations. But,

regrettably, history is strewn with visions of such "new eras" that, in the end, have proven to be a

mirage. In short, history counsels caution.

Such caution seems especially warranted with regard to the sharp rise in equity prices during the past

two years. These gains have obviously raised questions of sustainability. Analytically, current

stock-price valuations at prevailing long-term interest rates could be justified by very strong earnings

growth expectations. In fact, the long-term earnings projections of financial analysts have been

marked up noticeably over the last year and seem to imply very high earnings growth and continued

rising profit margins, at a time when such margins are already up appreciably from their depressed

levels of five years ago. It could be argued that, although margins are the highest in a generation, they

are still below those that prevailed in the 1960s. Nonetheless, further increases in these margins

would evidently require continued restraint on costs: labor compensa- tion continuing to grow at its

current pace and productivity growth picking up. Neither, of course, can be ruled out. But we should

keep in mind that, at these relatively low long-term interest rates, small changes in long-term earnings

expectations could have outsized impacts on equity prices.

Caution also seems warranted by the narrow yield spreads that suggest perceptions of low risk,

possibly unrealistically low risk. Considerable optimism about the ability of businesses to sustain this

current healthy financial condition seems, as I indicated earlier, to be influencing the setting of risk

premiums, not just in the stock market but throughout the financial system. This optimistic attitude has

become especially evident in quality spreads on high- yield corporate bonds--what we used to call

"junk bonds." In addition, banks have continued to ease terms and standards on business loans, and

margins on many of these loans are now quite thin. Many banks are pulling back a little from

consumer credit card lending as losses exceed expectations. Nonetheless, some bank and nonbank

lenders have been expanding aggressively into the home equity loan market and so-called "subprime"

auto lending, although recent problems in the latter may already be introducing a sense of caution."