In a podcast with Rob Johnson of George Soros’ Institute for New Economic Thinking, Charles Goodhart and Manoj Pradhan offer an unusual explanation for secular trends in inflation. They say that a decline in the dependency ratio creates excess supply of workers relative to consumer, putting downward pressure on prices. This trend has started to reverse, so we will see upward pressure on prices. They say that this upward pressure will become visible soon after the virus crisis is over.
Think of this in worldwide terms, with the dollar as the universal unit of account. Over the last several decades, the world labor supply rose because of population trends and the inclusion of more countries, notably China, in the world production system. The share of consumers in the population remained steady, as a decline in birth rates offset population aging by reducing the growth of young dependents.
Going forward, the labor supply will grow slowly and population aging will outpace any further decline in birth rates. So the world dependency ratio will rise, and this will put upward pressure on wages and prices.
Note that money plays no role in this story. What about “Inflation is, anywhere and everywhere, a monetary phenomenon”? Perhaps if you include the hypothesis that the real mission of the central bank is to hold down government borrowing costs, you can tell the story in a way that Milton Friedman would not object. That is, as dependency ratios were falling, there was enough worldwide saving to keep down interest rates, and central banks did not have to monetize a large share of government debt, so that inflation fell. Going forward, worldwide saving will fall, and central banks will face a dilemma. As inflation appears, they will want to stop it by raising interest rates. But if they do that, governments won’t be able to afford the interest cost on their debt, so central banks will be forced to monetize a large share of debt.
Toward the latter part of the podcast, they are asked about why markets differ from their forecast. Basically, they say that markets are extrapolating forward based on the past, in which demographic pressure on inflation was downward. It will take markets a while to realize that we are in a new regime.
Similar observations here:
“On the inflation side, population growth affects the inflation rate positively, most likely through its influence on lower aggregate demand and the slow supply responses for which specific channels have yet to be examined. In this vein, the ongoing demographic changes—both shrinking and aging—could have a sizable deflationary impact in the coming years. These dynamics involving demographic changes would change the framework of macroeconomic policies.
Taking the discussion of monetary policy as an example, one of the most popular ways to conduct and/or analyze monetary policy is via a reaction function that relates the policy short-term rate to a few variables that capture the state of the economy. The most well known is the rule set forth by John Taylor, under which the setting of short-term interest rates responds to inflation and the output gap as well as the equilibrium real interest rate. Population dynamics could affect the independent variables in this reaction function.
First, the equilibrium real interest rate can depend on both the growth rate of the population and the age composition of the population. It is, furthermore, challenging to nail down this relationship. The dependence on population growth is related to how the society treats different generations when there is population growth. Regarding the population composition, different assumptions with reference to the demand structure in an aging society would yield different implications pertaining to the real interest rate.
Second, the concept of the output gap depends on how the potential output is measured, which clearly depends on the population dynamics. Especially when the age structure changes over time, the potential output will depend critically on the assumptions regarding the labor participation rate and retirement age. Any disagreement on the potential output would cause different policy prescriptions with regard to the short-term policy rate.
Last but not least, the direction of the policy rate depends on whether the actual inflation rate is above or below its target rate. In principle, the target rate can be set independently of any other variables in the economy if we follow the monetarist doctrine. However, when population dynamics affect other target variables—such as the equilibrium real rate and the level of potential output—any misspecification in other parts of the economy would amount to unwanted inflation dynamics, and the inflation rate may not converge to its target as policymakers intend.”
YOON J-W, KIM J, LEE J. Impact of Demographic Changes on Inflation and the Macroeconomy†. kdijournalofeconomicpolicy [Internet]. 2018 Feb 28;40(1):1–30.
http://kdijep.org/v.40/1/1/Impact+of+Demographic+Changes+on+Inflation+and+the+Macroeconomy†
Thanks, Arnold, for the reference. I have just got the book CG & MP wrote and on which the interview is based. It has taken some time for CG to put together the pieces of the puzzle we used to talk about in the 1990s when I lived and worked in Beijing (CG used to visit the Graduate of School of the central bank whose Director I advised).
I have to read the book to assess the argument about the decline of interest rates in the past 30 years and their prediction that the rates will increase in the next 30 years. In past comments to your posts on money, banking, and finance, I argued that the challenge was to explain the large increase in world savings and their impact on interest rates. In China, the increase in savings was largely intermediated by the state banks. The stocks of these banks’ deposits were already huge in the late 1990s and today they are incredibly large. CG and I used to discuss the possibility of a sudden change in the inflow of funds into the state banks, one that could trigger a crisis as if it had been a Ponzi game. Indeed, as Milton Friedman used to recognize, there is no need for governments to rely on inflationary financing when they can borrow, much better if they can do it at very low rates.
Thank you for this podcast link and recommendation Arnold.
I have felt for quite a while that demographic effects have been the least understood area in economics but I haven’t had much of an idea how to translate this intuition into any concrete falsifiable predictions.
In my opinion, this is the best bit of original economic theorizing we have seen in a very long time.
It seems the authors are predicting hyper-inflation. The markets do not agree, but “they say that markets are extrapolating forward based on the past . . . . It will take markets a while to realize that we are in a new regime.” We EMH devotés are not impressed.
I didn’t hear them predicting hyper-inflation, just substantial enough inflation to meaningfully bring down real levels of debt over a number of years. I got the impression that they thought allowing this to happen would be the best choice from a menu of bad policy options and that markets would ultimately agree even though this will ultimately not be good for many asset values.
Several questions come to mind:
How does this theory explain the 1970s? Inflation was high across the much of the world yet dependency ratios were falling as the baby boom generation began entering the workforce in the late 1960s and birth rates plummeted. China was not yet a factor.
China has been well integrated into the world economy for some time now and their labor market has been shrinking since 2016. In like manner, developed country populations have been aging for many years. Why was there no hint of a resurgence of inflation over the past, say, half decade? Wouldn’t we have expected greater inflation pressures during 2015-2019 than 2003-2007 under this theory?
In the US since 1995, Core PCE inflation looks as if it is the product of a central bank that generally wants inflation at 2% with a moderate preference for undershooting rather than overshooting. Does it seem more likely to anyone that the Fed had nothing to do with it and it was all demographics?
>—“How does this theory explain the 1970s? Inflation was high across the much of the world yet dependency ratios were falling as the baby boom generation began entering the workforce in the late 1960s and birth rates plummeted. China was not yet a factor.”
The falling dependency ratios that were no obstacle to inflation in the 70’s are the opposite of the predicted future increasing dependency ratios expected due to aging populations in industrialized countries. The point is that this aging will soon result in “too many mouths chasing too few goods” in advanced industrialized countries. In the 70’s there was a better match between increasing demand and an increasing amount of labor available to meet those demands. Plus a lot of excess money creation.
>—“Why was there no hint of a resurgence of inflation over the past, say, half decade? Wouldn’t we have expected greater inflation pressures during 2015-2019 than 2003-2007 under this theory? ”
I understand them to be saying that has been covered by borrowing in a way that will not be sustainable much longer.
>—“In the US since 1995, Core PCE inflation looks as if it is the product of a central bank that generally wants inflation at 2% with a moderate preference for undershooting rather than overshooting. Does it seem more likely to anyone that the Fed had nothing to do with it and it was all demographics?”
I didn’t hear them say “the Fed had nothing to do with it.” I do think it’s worth asking why it has been so much easier for the Fed to control inflation since 1995 than in the quarter century before that. I think they are saying that the answer to that question is demographics.
First, About seven years ago, Steve Randy Waldman at Interfluidity made similar “demographics of inflation” arguments in a string of posts around the time of Not A Monetary Phenomenon.
Second,
My impression is that it’s gradually getting harder to draw bright lines between capital and labor, and likewise between ‘consumption’ and ‘inputs’ needed to support production. We add in women or Chinese on the one hand, but then add in labor-substituting machines and IT on the other. If we start running low of labor-growth, it creates an incentive for more labor-like-machines growth.
I think the issue is much more technologically determined. For machine outputs benefiting from centralization and economies of scale, when international transport of atoms and bits is quick and cheap, and when there is plenty of accumulated capital, the marginal cost of output tends towards that of natural limits and resource endowments, which has created enormous deflation in certain items. For strictly human outputs, we have a problem of cost disease and rent-extraction by the Neo-Ricardian sectors.
Arnold, keen for your thoughts on this issue when applied into your normal macro framework of PSST.
On my commute home and using only my cell phone, I did some rough calculations of the “Dependecy Ratio” from 1969-2009. I calculated the ratio of the US population under 20 + the population 65 and over to the US population between those age groups. Here are the results.
1969 0.75
1979 0.92
1989 0.72
1999 0.71
2009 0.71
Given these results, it looks like the 1970’s saw a big increase in the dependency ratio in the US. Of course one could also assume a change in the age distribution breaks especially in the group 20-25 because of a higher portion of those people entering the labor force. If one allows for that the increase in the 70’s would be larger.
So there is some evidence for demographic influence on observed rates of inflation in the 70’s.
If inflation is “anywhere and everywhere a monetary phenomenon,” it would seem that we are experiencing inflation in asset prices (stocks, bonds, real estate, etc.), and not so much in CPI. (The way of calculating lodging costs, homeowner equivalent rent, tends to exclude RE prices from CPI). Could it be that with increased efficiency in production and distribution, and various hedonic adjustments, CPI inflation is kept low, while asset prices rise freely?
The simplest way to think about this matter is that central banks determine the supply of money (to be precise, the monetary base, which has a strong influence on broader monetary aggregates), but the public determines the demand. Goodhart and Pradhan offer an analysis of some important long-term factors affecting demand. If central banks that target inflation neglect those factors, they risk missing their targets because they lack a correct understanding of the demand for money.
Inflation is already here. It has happened.
In the ageing society marginal consumption is not in the present, but in the future retirement choices and options. A $25k bonus is not spent on upgrading one’s car (as would be a 20-year-old’s choice), but on beefing up retirement security.
And because of the financial asset valuations inevitably leading to lower (possibly negative) real returns, today’s $25k buys you a lot less consumption during your retirement time horizon. For instance, in nominal terms let’s handicap expected returns at 2% now vs 5% 10 years ago. This means the price of your retirement in 20 years’ time in terms of today’s dollars went up about 80%. The math is simple:
$25k at 5% returns gave you $66.3k worth of retirement in 20 years.
To get $66.3k at 2% returns you need $44.6k today,
Maybe the issue isn’t economics but politics.
Could an older population (who are creditors) like low inflation or deflation? And a younger population with debt (student loans and mortgages, all fixed rate) like inflation?
They can vote for policymakers. Milton Friedman would understand with George Stigler. Inflation is anywhere and everywhere a political phenomenon.
Interesting post and a lots of good comments.
Of course, there is always the chance that if labor becomes more expensive or dear, then we will see much more investment in labor-enhancing capital equipment.
A country with “labor shortages” is a happy nation, by the way.
Keep labor markets tight and property markets loose, and you have the recipe for a stable democracy.
See Japan.