Kudlow's Corner

Janet Yellen’s back-to-the-’50s interest rates

Janet Yellen told us last week that the Fed-funds target rate will be raised slightly later this year. But after that, future rate hikes will be small and gradual over the next several years. In fact, we may never have true normalization (4 percent). In my view, Yellen is offering a back-to-the-'50s approach to interest rates. And she's right, though for many wrong reasons.

Janet Yellen
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For average folks, what might this policy mean? I'll take a guess: No boom and no bust. No inflation and no recession. All the post-war recessions were preceded by an inverted Treasury yield curve, where short rates are higher than long rates. That won't happen for many years. Plus, upward oil-price spikes lead recessions, but we're now in a downward energy-price cycle.

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What's the back-to-the-'50s part? Well, from Eisenhower to JFK, short rates averaged between 1 and 2 percent, inflation was roughly 1.5 percent, the dollar was tied to gold, long Treasurys ranged 2 to 3 percent, and real growth was only 2.5 percent. And despite Ike's three recessions, the stock market roughly doubled (from very low levels).

So that was then, and this is now. Things are different. But the ultra-low interest rates are quite similar, along with low inflation and virtually stagnant real growth.

As for fiscal policy in the '50s, the top personal tax rate was 91 percent (effectively about 70 percent) and the top corporate tax rate was over 50 percent. And the economy was heavily regulated. Sound a bit similar? It wasn't until the'60s that JFK slashed tax rates and launched a huge economic and stock market boom. But that's another story.

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Meanwhile, why might Yellen get it right today for the wrong reasons? Well, for one, she wants higher inflation, which is a mistake. We used to think that lower inflation promoted faster economic growth. And we should be watching the value of the dollar as indicated by commodity indexes, including gold. Fortunately, the dollar is trending higher and commodities lower.

So let me say this: A sound dollar and price stability should be the Fed's only task. But Ms. Yellen is a Phillips-curver who sees a trade-off between inflation and growth. She obsesses about the jobs market as a Fed-tightening indicator. Wrong target. More people working does not cause inflation. Bad money does.

But Yellen is right in pointing out employment problems. We have a 5.4 percent U-3 unemployment rate, the commonly watched measure. But in this cycle, the broader U-6 measure may be closer to the truth at 10.8 percent. U-6 includes part-time people who want full-time work, discouraged people who are sometimes looking for work, and people who have left the labor force.

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And when you add up U6 and U3, you get something like 16 million people out of work. And then the government's welfare-assistance programs (including disability insurance, food stamps, and Obamacare) pay people not to work, which is a key reason why the labor-force participation rate is rock bottom at 62.8 percent and the employment-to-population ratio is only 59.3 percent. This will not be fixed by the Fed. It's a fiscal issue of tax, regulatory, and welfare reform.

So, Yellen is right about an incomplete jobs recovery. She is also right about the lack of capital investment by businesses, where more capital would boost productivity. But that's not the Fed's job. The most important pro-growth policy today would be major corporate tax reform — slashing tax rates and moving to a territorial system that would bring home roughly $2 trillion stashed overseas, mostly for tax reasons. Think how much better the jobs picture would be if that money came home.

Putting that aside, the Fed is right to go slow with rate hikes. Back in the '50s we had ultra-low interest rates for long periods of time and it was not a bad thing. The trick is to avoid Ike's mistakes of over-taxing and over-regulating the economy.

And that brings us back to the future — namely the 2016 presidential election.

Commentary by Larry Kudlow, a senior contributor at CNBC and economics editor of the National Review. Follow him on Twitter @Larry_Kudlow.