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Fear Not Higher Rates
Economists of days past say the Fed should act.


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Larry Kudlow

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 on Wednesday.

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For those who may not remember, 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 occasional message-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.

Confirming this, commodity prices (including gold) will rise or fall depending on central bank policy. Over the past year the pronounced 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 good thing and 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 presently just under 2 percent. Of course, the central bank policy rate is the 1 percent federal funds rate.

Therefore, according to the Swede, Greenspan & Co. can adjust their policy from one of substantial ease to something close to neutral with just three or four quarter-point rate hikes in the remaining months of the year. There’s no reason they can’t begin right away at the very next open-market meeting on May 4.

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. This is what the widely followed Eurodollar futures curve is predicting. Traders have priced in a 3 ½ percent fed funds rate by the end of next year. That’s a big jump.

But Wicksell had more to say last night: He urged caution about predictions for 2005. One step at a time, he told me. 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.

Importantly, there is no need for a repeat of 1994, when the Fed mistakenly overreacted by taking the policy rate from 3 percent all the way up to 6 percent — only to bring it back down to 4¾ percent in the next couple of years.

Before signing off, Wicksell urged me to be available for an upcoming message from the eminent Austrian economist Joseph Schumpeter — who died in 1950 but fortunately checks in from time to time. Schumpeter, you may recall, created an economic growth model that relies on rapid technological advances, invented and commercialized by risk-taking entrepreneurs who put their God-given talents to work in a free-market economy. These technological outbursts drive economic prosperity to unimaginably higher levels through their widespread applications. “Gales of creative destruction” was what Schumpeter called it.

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

All this growth will absorb any excess money and hold back inflationary pressures. Growth is inherently counter-inflationary. Indeed, rapid advances in biotech, nanotech, and a myriad of wireless-communication networking equipment are poised to unleash phenomenal economic opportunities throughout every nook and cranny of American life.

Wicksell and Schumpeter make a great team. Were they on Wall Street today they’d counsel the stock market not to be afraid of a few small interest-rate increases. Least of all the Federal Reserve. Rate hikes are part and parcel of a normal prosperity cycle, one that can extend for another eight or ten years.

So put any and all of 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.

— Larry Kudlow, NRO’s Economics Editor, is CEO of Kudlow & Co. and host with Jim Cramer of CNBC’s Kudlow & Cramer.



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