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A declining workforce and its impact on inflation

A declining workforce and its impact on inflation

Issues to be addressed in this research paper

A colleague of mine raised a very valid question:

We all seem to think that ageing can only lead to lower inflation, all other things being equal, as older people consume considerably less than younger people do. What if we are all wrong? What if a shrinking workforce actually leads to bottleneck problems, which could drive inflation much higher than nearly anyone expects?

As there is virtually no economic theory to support whatever conclusion you may arrive at, the financial community has for many years relied on empirical evidence. The prevailing view for many years was actually very close to my colleagues' thinking, i.e. that ageing would lead to a shrinking workforce, which would push wages (and hence inflation) higher.

That view changed almost 180° as the experience from ageing in Japan turned out to be anything but inflationary, and today the prevalent view is that ageing is at least disinflationary, and perhaps even deflationary.

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The lessons from Japan

Going back to Japan for a second, it has for many years been considered a prime example of how bad things can possibly go in continental Europe, as it suffers from demographic conditions not too dissimilar to those of Japan.

As you can see from chart 1 below, in Japan, core CPI has been closely linked to the size of the workforce for many years, leading many (me included) to conclude that it is only a matter of time before the Eurozone falls into the same trap. The average age in Japan is higher than almost anywhere else in the world, driving the argument that we should learn from the Japanese experience. As I have frequently pointed out, the picture here in Europe is not quite as bad as it is in Japan, but it is certainly bad enough to warrant some concerns (chart 2).

Chart 1: Japanese working age population vs. core CPI
Chart 1:  Japanese working age population vs. core CPI
Source: Barclays Equity Gilt Study 2014
Chart 2: Long term working-age population projections
Chart 2: Long term working-age population projections
Source: Goldman Sachs Investment Management, United Nations, 2015

BIS’ latest research on the subject

Roger’s question got me thinking. Could anything possibly cause a different outcome? After all, Japan’s status as a creditor nation, its next-to-zero immigration population and low female participation in the labour force makes it a less than optimal comparison to Europe and the U.S.

One minor caveat: In the following, I will follow the general approach in our industry and look at inflation vs. dependency ratios rather than inflation vs. the size of the workforce. The dependency ratio is defined as the number of dependents (those aged 0-14 and 65+) to the total working population (those aged 15-64). As the two are virtually perfectly negatively correlated, you would expect a rising dependency ratio (more children and/or elderly) to lead to disinflation, just like it did in Japan.

Somewhat surprisingly, The Bank for International Settlements (‘BIS’) reached a fundamentally different conclusion, when they researched the topic in 2015. They found that, in most countries, inflation has moved more or less in tandem with the dependency ratio, i.e. the more dependents, the higher the rate of inflation and vice versa (chart 3).

Chart 3: The link between inflation and the dependency ratio in various countries
Chart 3: The link between inflation and the dependency ratio in various countries
Source: BIS Working Paper 485, Bank for International Settlements, February 2015

Critique of BIS’ research

Before I reach any conclusions, let me share with you some of the issues one might have with the BIS study.

Firstly, and as mentioned already, the dependency ratio is calculated as the sum of those aged 0-14 and those aged 65 or older. Could it be that a rising dependency ratio in the years to come is driven by more youngsters rather than more old people? The answer is no (charts 4-5).

Chart 4: Young children and older people as % of global population (1950-2050)
Chart 4: Young children and older people as % of global population (1950-2050)
Source: Deutsche Bank, United Nations. Haver Analytics, April 2016
Chart 5: Old-age dependency ratios in various countries
Chart 5: Old-age dependency ratios in various countries
Source: Robeco, European Commission, 2016

Secondly, and somewhat related to the first issue, could it be that youngsters affect inflation much more than the elderly do? After all, we all know that children are tremendously expensive. BIS looked at different age groups’ impact on inflation and, although young people impact inflation more than the elderly do, BIS found the difference to be surprisingly small (chart 6).

Chart 6: Age cohort effects on inflation
Chart 6: Age cohort effects on inflation
Source: BIS Working Paper 485, Bank for International Settlements, February 2015

Thirdly, the BIS study doesn’t distinguish at all between different age groups in the 65 and over category. In reality, it makes a major difference how old that age group is on average. After all, I know from other research studies that people aged 70 spend a lot more money than those aged 85, and they spend it very differently. BIS doesn’t address this issue.

Talking about the over 65s, they are increasingly staying in the labour force past their normal retirement date – at least in the U.S. (chart 7). If this trend were to continue, the impact of ageing will obviously be less dramatic than perceived.

Chart 7: U.S. employment to population ratio – 65 years and older (%)
Chart 7: U.S. employment to population ratio – 65 years and older (%)
Source: Deutsche Bank, BLS, Haver Analytics, April 2016

Fourthly, either economic or political factors can drive the demographic impact on inflation. BIS found in its research that, although both sets of factors have indeed impacted inflation over time, the effect from changing economic conditions is greater than that of political factors. This is important, as it makes BIS’ findings more robust.

Fifthly, if you take another look at chart 3, you may note that the spike in inflation in the late 1970s and early 1980 not only coincided with a peak in the dependency ratio; it also happened at the same time as the second oil crisis and the ensuing inflation calamity. Is it possible that the apparent link between demographics and inflation is just a coincidence? That inflation is in reality driven by economic factors like oil prices? BIS tested for this and found their results not only to be statistically significant but very robust.

Finally, I should point out that, despite the robustness of BIS’ findings, other research papers have arrived at different conclusions, and that many remain convinced that ageing is actually disinflationary. It is therefore fair to say that one shouldn’t assume that the BIS research paper is akin to the holy grail.


BIS offers the following explanation as the primary reason why old people actually impact inflation much more than generally perceived:

It is not that they spend more than everyone thinks they do. Older people definitely consume less than the younger generations, which in itself is disinflationary. However, they consume a lot more than they produce (which is next to nothing), which is inflationary.

Think of it as a classic supply and demand function. Demand falls as consumers age, but supply falls more. BIS’ argument is therefore a relative one, not an absolute one. The two curves simply meet at a different point, causing prices to rise. BIS expects the inflationary trend to remain in place for a very long time to come – at least for the next 30-40 years in Europe.

I am not saying that BIS is definitely right and the rest of us wrong but, if its findings are anywhere close to the actual outcome, the rather benign inflation environment of the last 30 years will reverse in the years to come, and we will enter a more challenging environment. The impact from rising dependency ratios will vary somewhat from country to country, but we will all be negatively affected (chart 8).

Chart 8: Demography’s impact on inflation – past and future
Chart 8: Demography’s impact on inflation – past and future
Source: BIS Working Paper 485, Bank for International Settlements, February 2015

Having said that, I should point out that ageing is only one of many factors that impact inflation. There is absolutely no reason to expect a repeat of the inflation mayhem of the late 70s and early 80s.

Finally, I should also mention that BIS’ findings in no way imply that GDP growth will also confound expectations, just like inflation may do. Regardless of what happens to inflation, GDP growth is likely to stay muted for a long time to come. It is therefore not entirely unthinkable that we end up with a very unpleasant combination of low GDP growth and relatively high inflation.

Niels Jensen

11 May 2016

About the Author

Niels Clemen Jensen founded Absolute Return Partners in 2002 and is Chief Investment Officer. He has over 30 years of investment banking and investment management experience and is author of The Absolute Return Letter.

In 2018, Harriman House published The End of Indexing, Niels' first book.