Don't fear those rate increases

Knut Wicksell dialed in late last night to tell me not to panic over the imminent change in Federal Reserve rate-hiking policies signaled by Alan Greenspan's congressional testimony last week.

Wicksell was the brilliant Swedish classical economic philosopher who understood money and central banks as well as anyone in the profession. He died in 1926, but I am grateful for his communions across time and space.

Wicksell's monetary model is a simple one. When the central bank's policy rate is placed above the economy's so-called natural rate, then money is tight. When the rate is set below the economy's potential to grow and invest, then money is easy.

Define "tight" and "easy". Any time the money supply grows, the feds rate is above that of the "natural rate". This follows from the definition of "natural rate", i.e., the rate that one person or bank will lend real money to another, not money counterfeited from the Fed. The money market rate is a good measure of the "natural rate of interest".

Confirming this, commodity prices will rise or fall depending on central bank policy. Over the past year, the rise in commodity prices and the fall in the dollar have been signaling that excess money from the Fed has created a mild inflationary potential. That Alan Greenspan has apparently decided to remove some of this liquidity excess is a prudent decision. Expecting Fed restraint, gold plunged and the dollar surged in recent days, signs that virulent inflation is not in the cards.

We can easily tell the so-called natural rate today by observing the yield of the inflation-protected Treasury bond, which trades daily in the open market. The yield is currently just under 2 percent. Now, the central bank policy rate is the 1 percent federal funds rate.

This is low because of Asian buying of treasury bonds to bolster exports, but it approximately agrees with the money market rate.

Therefore, Greenspan & Co. can adjust their policy from one of substantial ease to something close to neutral with just three or four quarter-point rate increases in the remaining months of the year. They could begin at the open-market meeting next Tuesday.

It could well be that the economy's natural rate, which reflects the longer-run productivity of both workers and investments, might rise above 2 percent. In that case, a neutral Fed policy in pursuit of domestic price stability would have to take short interest rates higher. Traders in the widely followed Eurodollar futures curve have priced in a 3 percent fed funds rate by the end of next year.

But Wicksell urged caution about predictions for 2005. Lower tax rates on investment will make scarce capital much more plentiful than in the past. This, in turn, could hold real rates lower than might otherwise be the case.

Schumpeter created an economic growth model that relies on rapid technological advances. These technological outbursts drive economic prosperity to unimaginably higher levels.

Undoubtedly, Schumpeter will tell me that unprecedented new capital formation — unlocked by the significant decline in high marginal tax rates on investment put in place a year ago — will generate more technological advances, higher productivity, big gains in profits and wages, and ever-greater economic growth.

All this growth will absorb excess money and hold back inflationary pressures. Growth is inherently counterinflationary. Indeed, rapid advances in biotech, nanotech and wireless-communication networking equipment are poised to unleash phenomenal economic opportunities.

True, natural deflation checks monetary inflation, but deflation is great for savers and wage earners. Savers should not be continually be robbed by the Fed. A likely rise in petroleum prices would cause natural inflation, which would reinforce the absurd amounts of monetary inflation.

So put your interest-rate panic to rest. Disregard the Cassandras and the pessimists. They've always been wrong for this great country. Good times are coming. That's what free economic opportunity brings.

He can't be serious! Depleted commodity inflation (petroleum, natural gas), government debt induced inflation and housing inflation may well outstrip productivity, and technological deflation in all but electronics, and sensors. We have been setup for a recession and that is exactly what we will get.