Peacetime-Wartime; Inflation-Deflation; the Trump Era Begins

David R Kotok

Cumberland, November 14, 2016

Shilling is a well-known name in the circles of economics and financial markets. I’ve had the pleasure of fishing with him and tasting his superb honey – he is a beekeeping hobbyist. Gary and his team are deeply thoughtful and often provocative.

In his latest monthly missive he reiterates a position that warrants reflection. He concludes one section of his report with this observation: “If peace is the norm in the years ahead, history implies deflation.” That strategic assumption is profound with regard to the outlook for interest rates and for markets. And it must give some pause to central bank policymakers.

Gary is thinking strategically and not about month-to-month data fluctuations. He supports his argument with over two and a half centuries of US data. He notes that there were 96 years of wartime in that period. He lists all of them. During wartime, the average change in annualized wholesale price inflation was 5.85%.

Gary points to about 170 years of peacetime. The average annualized wholesale inflation was a negative 1.14%.

Some of this data is ancient, like that for the Revolutionary War and the French and Indian War. So someone might well say there is a question about data gathering and that the world is quite different now. Maybe so, but the pattern is the same if we look at just the last century.

The two years of World War I inflation (1917–18) averaged about 24% annualized. The peacetime period between the two world wars (1919–1940) averaged a negative 2.3%. Gary’s conclusion is validated in the first half of the last century.

Five years of World War II (1941–5) averaged 6% annualized wholesale price inflation. The ensuing Cold War period (1946–1992) lasted 47 years and averaged a 4.2% annualized wholesale price change.

Gary calls the 8-year period from 1993 to 2000 period a peacetime era. Inflation averaged 1.4%. He notes that the War on Terror began in 2001 and lasted 13 years, to 2014. Annualized wholesale price inflation averaged 2.8%.

Are we in peacetime now? Gary would argue that we may be.

Sure, the world looks dangerous and threatening today, but in the United States defense expenditures as a percentage of GDP are shrinking, and we are acting more like we are in a peacetime era than a wartime era. I know I will get emails about this, and emailers’ fingers will be pointing at ISIS and the South China Sea and North Korea. All true. But how much defense spending has been deployed versus past wartime periods? The aggregate data says very little. Gary supports this view by noting that over the last two years we have averaged an annualized wholesale price level change of 1.2%.

What will the outcome of the election and the new composition of the Senate and House mean for the wartime versus peacetime macroeconomics of the United States? Set aside the political rhetoric. One can make an interesting case for the continuation of a peacetime level of defense spending relative to the nation’s GDP.

The old political adage regarding guns and butter applies. When it is just butter and the guns are quiet, the inflation rate is low.

We looked at another source independent of Gary to see if we could find a similar pattern. The book is Prices, by George Warren and Frank Pearson, two distinguished giants of the economics profession who published their magnificent work in 1933. It was the ultimate reference for its time and went through six printings by Wiley. Imagine writing a book about prices when your research period started in the year 1720 and ended during the Great Depression era.

What the Warren-Pearson treatise does is validate Gary Shilling’s view and his numbers. The implications for growth rates and interest rates and the world’s economic recovery are profound.

Will we have the economic characteristics of a peacetime in the United States for the next four years? We shall see what unfolds in this dangerous world. But if we do have peacetime, reflation is destined to be mild. That implies the uptrend in interest rates will be mild, too. Gradually rising rates – but no jarring spike – may lie ahead. For now we agree with this forecast.

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David R Kotok, Chairman and Chief Investment Officer, Cumberland Advisors