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.
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 percent fed funds rate by the end of next year. That?s a big jump.
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