The worrywarts are talking about rising interest rates now that the economy is clearly moving ahead on all cylinders. But they're getting all stressed out over nothing.

I know this for certain because I communed with the spirit of Knut Wicksell a few days ago. Knut, the Swedish classical economist, has been dead for 77 years, but an economic model he developed is still one of the best ways to think about central bank policy. Knut confirmed that my thinking on interest rates is right on track.

His model goes like this: When the central bank policy rate (or, in the case of the United States, the federal funds rate) is set above the economy's natural interest rate (which can be viewed in the 10-year Treasury inflation-protected security, or TIPS), then monetary policy is relatively stingy. Conversely, when the policy rate is set below the natural rate, the reserve provision is plentiful, even excessive. And when the policy rate is aligned with the natural rate, the central bank is in neutral.

For over a year, the fed funds rate has been lower than the real TIPS rate -- an appropriate response to deflationary pressures, especially deflationary drops in business pricing-power. Presently, the fed funds rate (1 percent) is below the TIPS rate (about 2 percent), so high-powered money creation is keeping the Fed in an excess reserve position.

Consequently, real-time market-price indicators (like gold and commodities) have been rising -- a sure sign that the Fed's excess-money policy has been working -- while business prices are still muted, indicating that inflation is not a worry.

Greenspan & Co. deserve credit for good policy stimulus over the past 15 months, and also for accommodating the latest Bush tax cut by reducing the policy interest rate this past June. That tax cut was aimed especially at capital-formation incentives for investor dividends, capital gains, small businesses and faster write-offs for the purchase of business equipment, and it needed a loose central bank to feed it.

Interest-rate futures markets are signaling a higher Fed policy rate next year, perhaps a fed funds rate as high as 2.5 percent. But there is no need for the Fed's policy rate to be set at a deep discount to the economy's natural rate.

The combination of the Fed's successful easy-money program and the Bush tax cuts have pushed real investment returns, real profits, real wages and real economic growth nicely upward. Hence, the so-called natural (or real) interest rate is likely to rise in the period ahead. The Fed should follow this and gradually shift its policy rate from highly accommodative to neutral.

Look for the central bank to begin this process in March or April of 2004. Assume a Greenspanian gradualist approach: one-quarter-point at a time. Continued...