One Armed Fed

The Fed’s current focus on inflation over full employment may be a preview of monetary policy in a world where the supply of labor is structurally declining. An aging population implies a persistent decline in the supply of labor, even as demand for labor remains strong because retirees continue to consume. The economic implications of this new regime are previewed through the recent wave of early retirements: lower unemployment, higher wages, higher inflation, and weaker growth. These circumstances reduce the employment costs of tighter policy, potentially changing the Fed’s reaction function by freeing policy to more aggressively target inflation. Recall, the Fed’s mandate is full employment and price stability, not positive economic growth. In this post we review a theory on how aging demographics raise inflation, illustrate its implications with the recent wave of early retirements, and suggest higher interest rates will become structural.

Goodhart’s Theory on Demographic Inflation

Professor Charles Goodhart posited that aging demographics would be inflationary as a decreasing labor supply from retirements would intersect with increasing consumption in old age. He noted that the integration of China and Eastern Europe into global trade amounted to a tremendous surge in the global supply of labor that led to decades of subdued inflation. But that effect would reverse as increasing life expectancies and low birth rates across the world cause the workforce to shrink as a percentage of the population. This can be already be seen in the U.S., where the the prime working age population that steadily increased for decades has now plateaued. An even more dire trend appears in Europe and China, where the prime working age population actually declines sharply.

U.S. demographics. Source: United Nations

Although the supply of labor declines from demographic aging, the demand for labor does not necessarily decline because retirees continue to consume. Retires may purchase fewer cars and houses, but research suggests their overall consumption actually increases due to higher expenditures on healthcare. Note that boomers are wealthy and also receive government transfer payments, so they can finance consumption even without labor income. When a persistent demand for labor meets a declining supply of labor, then wages increase and inflation reemerges.

Per Capita Consumption, Private and Public by Sector, United States, 2000. Source: Lee, Ronald et al. “Charting the Economic Life Cycle.”

Pandemic Case Study

The economic impact of early pandemic retirements offer evidence in favor of Goodhart’s theory. Labor force participation dropped for all age demographics in 2020, but everyone came back to work except the boomer generation. The pandemic appeared to accelerate the retirement decisions of boomers, who may have left the labor force due to health concerns or an improved financial position. This contributed to a shortage in labor, shown by job vacancy rates that are historically high and a labor force today that is actually smaller than it was in early 2020.

Source: “How Many Workers Are Truly “Missing” from the Labor Force?” Didem Tüzemen. FRB Kansas

The shortage of labor has led to a surge in wages and contributed to the broadening of inflation. Wages are growing at the fastest pace in decades, with increases seen in all segments of the labor market. This contributes to cost push price increases because wages are a large expense for many businesses, with non-financial corporations paying $5t in wages in 2020. Higher wages in turn also imply that consumers can afford higher prices, potentially unleashing a wage price spiral.

Source: FRB Atlanta

Secular Stagflation

A declining supply of labor affects the optimal policy response to high inflation or poor economic growth. With respect to inflation, the standard playbook of raising rates to dampen aggregate demand would have less of a negative impact on employment. This opens the door to a more aggressive monetary policy focused largely on price stability.

A declining supply of labor also weakens the link between recession and labor market slack. Recessions could arise simply from increasing retirements leading to fewer workers. The standard playbook of cutting rates would not make sense in that context, as the economy would remain in full employment. In fact, rates would have to be structurally higher to counter the inflationary impact of a steadily shrinking labor supply.