Knut knows interest rates

Larry Kudlow
Posted: Nov 14, 2003 12:00 AM

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.

And now back to the worrywarts: As Fed rate-hiking proceeds, economic activity will accelerate, not decline. Working Americans will make use of higher after-tax returns by spending and investing ahead of future financing rate hikes. This is the reverse of what happened in 2001 and 2002, when falling rates caused folks to defer activity until they could capture the lowest possible financing costs for homes, businesses, or personal use.

Interest-rate jitters seem to have infiltrated the stock market sometime in late June. But rising interest-rate expectations have not inflicted any real damage on the market's optimism. Importantly, rate rises will come from higher real returns, not higher inflation.

Sure, some will argue that faster economic growth is inflationary, but this is a classical demand-side view. Supply-siders know that more people working, investing and prospering cannot possibly be inflationary. In fact, more goods chasing the available money supply will actually hold inflation down. So will rapid productivity gains and low unit-labor costs. So will lower taxes, which are also counter-inflationary.

Strong growth at a time of more normal interest-rate levels is a very prosperous outlook that will carry share prices higher. Periodic market corrections will occur, but smart investors will buy on the dips.

And the markets will thank the Fed for following the Wicksellian paradigm. As Greenspan & Co. bring the policy rate into balance with the economy's natural rate (probably about 3 percent over the next 18 months), the dollar will stabilize and inflationary fears will be minimal.

At least that's what Knut told me when we last spoke. That is, when we last communed.