No early retirement for demographic-driven inflation risk
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The writer is a former chief investment strategist at Bridgewater Associates
While moderating inflation and more benign interest-rate expectations have helped boost markets this year, there is a more structural risk that remains under-appreciated: demographic decline.
Policymakers have recently homed in on challenges stemming from ageing populations alongside shrinking workforces. But so far, their responses are woefully inadequate to prevent higher rates of inflation and more difficult fiscal trade-offs in the years ahead. This in turn suggests a greater probability of higher interest rates, as well as more policy uncertainty that weighs on spending and investments, both a drag on cyclical assets including equities.
Demographics are often shrugged off — too slow moving, too far away. So why the policy focus now? Like many economic forces today, it comes back to the pandemic. Participation of those aged 55 and older fell sharply during Covid-19, stabilising now in the US around 15-year lows below 39 per cent. This larger than expected cut to the labour supply helped push wages up to multi-decade highs and left many companies struggling to meet production goals.
The rise in inflation has also put governments under political pressure and central banks have had to pursue the fastest tightening cycle in decades to bring inflation back towards targets, slowing growth. This has left companies facing increased wage demands even as the economy slows.
While policymakers have taken note, action so far is unlikely to materially assuage near-term voter unhappiness or longer-term economic risks. In France, protests over a push to raise the retirement age from 62 to 64 are evidence of how politically contentious it is to address demographic challenges.
Only Canada among the larger economies seems willing to pull out the stops to meet labour needs, dramatically raising immigration goals and targeting half a million new immigrants in 2025. Immigration now accounts for nearly all the country’s labour-force growth and 75 per cent of overall population growth.
Without significantly more immigration, more children, longer working hours and lives, and/or more technology to increase productivity, we face a combination of lower labour output combined with a larger group of dependants. The degree of the demographic challenge can be debated, but the risk for longer-term inflation and fiscal policy is not sufficiently discounted.
Even without the union participation seen in the 1970s, labour supply trends will give workers more bargaining power in the years ahead, which should provide sustained support for wages. Further, without an offsetting increase in productivity, a smaller labour force suggests production will struggle to keep up with the broader population’s consumption — an additional inflationary dynamic. Contrast that picture with signals from trading in US Treasury inflation-protected securities. That implies annual inflation is expected to be about 2.2 per cent on average over 10 years.
Disinflation optimists will understandably point to Japan’s experience in recent decades to question the link between a growing dependency ratio and inflation. However, it’s important to note at least two factors that helped Japan keep wages and prices low that may not be replicable in other ageing countries. First, the Japanese have stayed in the workforce longer, which seems less likely in other countries where retirees appear content and financially able to remain on the sidelines. Second, Japan was able to increase its labour pool in recent decades via overseas investment and manufacturing that relied on foreign workers — this will be less politically palatable for many governments that would rather reshore.
Beyond inflation, we should expect more difficult fiscal trade-offs for governments. Policymakers will increasingly have to choose between reducing expenditure in politically sensitive areas such as elderly-related spending programmes, raising taxes or accepting wider budget deficits. In the current polarised state of many countries, reaching any decision will be noisy, to say the least.
For markets, these demographic headwinds should result in interest rates settling relatively higher. In addition, we should expect higher labour and borrowing costs to weigh on profit margins. Sustained higher levels of political uncertainty can also leave individuals wary on spending. Just as sentiment feeds into equity valuation multiples, more cautious investment and spending will flow through to earnings.