Larry Kudlow

At this week's Federal Reserve meeting, the benchmark policy rate was held at its lowest level since 1958, and according to the Fed's policy statement it will remain there for "a considerable period." The stock market cheered loudly on this news. But the wording of the Fed's statement did little to prepare markets for the growing likelihood that the federal funds interest rate and other market rates will rise next year.

Right now, election year or not, the fed funds futures market is predicting quarter-point rate increases next May and June. Euro-dollar futures anticipate a 2.5 percent funds rate by December 2004 (the overnight rate is now 1 percent) and a 3.5 percent target rate by December 2005.

Ultimately markets will process information on the economy and inflation to make their own judgments about interest rates. But there currently seems to be a big debate inside the Fed over how much the central bank should attempt to use public statements to manage interest-rate expectations. Last spring, remember, the Fed's attempt to jawbone long-term rates backfired -- the 10-year Treasury note went up about 150 basis points, a full-scale revolt against the Fed's suasion. Undoubtedly there's an important lesson here: Don't try to fool financial markets -- they're bigger than you are.

No matter what the Fed says, if the economic recovery continues to register a strong 4 percent to 5 percent growth rate in the next two quarters -- following the consensus estimate of 6 percent for third-quarter gross domestic product (to be released Thursday) -- interest rates will be rising next year.

The 10-year inflation-adjusted rate (or the so-called natural rate) is now hovering around 2 percent. This is way below normal. It will adjust upward by at least a percentage point in the next year. Much of this upturn in the real rate will come from stronger-than-expected business investment. Lower tax rates on capital formation (dividends and capital gains) and faster tax write-offs for business purchases of capital-goods equipment will promote higher investment returns and greater credit demands, all exerting an upward bias on interest rates.

Though commodity prices have been booming and gold is at the upper end of its safe-haven range, inflation expectations currently don't look like much of a serious threat. Over the past year, the Fed has done a good job of reflating the economy and stabilizing core producer- and consumer-price levels.


Larry Kudlow

Lawrence Kudlow is host of CNBC’s “The Kudlow Report,” which airs nightly from 7 p.m. to 8 p.m.
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