Wednesday, August 24, 2016

Historical Relationship between Inflation and War

We’ve argued that the root of inflation is excess demand, and historically it’s caused by huge government spending on top of a fully-employed economy. That happens during wars, and so inflation and wars always go together—going back to the French and Indian War, the Revolutionary War, the War of 1812, the Mexican War of 1846, the Civil War, the Spanish American War of 1898, World Wars I and II, and the Korean War. In the late 1960's and 1970's, huge government spending—and the associated double-digit inflation from the Vietnam War topped LBJ’s War on Poverty.


By the late 1970s, however, the frustrations over military stalemate and loss of American lives in Vietnam as well as the failures of the War on Poverty and Great Society programs to propel lower-income folks led to a rejection of voters’ belief that government could aid Americans and solve major problems. The first clear manifestation of this switch in conviction was Proposition 13 in California, which limited residential real estate taxes. That was followed by the 1980 election of Ronald Reagan, who declared that government was the basic problem, not the solution to the nation’s woes.

This belief convinced us that Washington’s involvement in the economy would atrophy and so would inflation. 

Given the close correlation between inflation and Treasury bond yields, we then forecast the unwinding of inflation—disinflation—and a related breathtaking decline in Treasury bond yields to 3%. At that time, virtually no one believed our forecast since most thought that double-digit inflation would last indefinitely. 

We’ve been bulls on 30-year Treasury bonds since 1981 when we stated, “We’re entering the bond rally of a lifetime.” It’s still under way, in our opinion. Their yields back then were 15.2%, but our forecast called for huge declines in inflation and, with it, a gigantic fall in bond yields to our then-target of 3%.