What causes inflation? Old people and kids, according to a provocative new paper that suggests an outburst of higher inflation may be lying in wait for us.
Mikael Juselius and Elod Takats of the Bank for International Settlements point out that their findings turn conventional wisdom on its head.
Bank of Japan governor Masaaki Shirakawa, for instance, has argued that an aging population lowers inflation by reducing expectations for economic growth. Other commentators have suggested that elderly voters are more likely to support policies that protect the purchasing power of their savings.
But that's not what the bank researchers found when they looked at the evidence from 22 advanced economies, including Canada, between 1955 and 2010. They discovered that periods in which countries had high proportions of dependents – whether they were young people or oldsters – tended to be accompanied by higher inflation than periods in which the population was more concentrated in its prime working years.
"According to our estimates, demography accounts for around one-third of the variation in inflation and for the bulk of the deceleration between the late 1970s and early 1990s," they write.
They say their results "suggest a robust correlation between demography and inflation" although exactly why is unclear. It's possible that a high proportion of dependents means many people consume more than they produce, thereby raising inflationary pressures.
But while the co-authors urge caution in applying their results, their data suggest the developed world may be nearing a turning point.
According to their numbers, advanced economies have benefited from demographics that encourage relatively low inflation over the past four decades. But that situation is now on the verge of flipping and "the demographic pressure on inflation would be expected to reverse almost fully over the coming decades, from benign to more challenging."
Their estimates, taken at face value, suggest that a widespread increase in the share of the working age population has lowered inflationary pressure by about four percentage points on average over the past 40 years. Over the next 40 years, the growing numbers of elderly citizens will have the opposite effect, raising inflationary pressure by about four percentage points.
It's important to note that the researchers are referring here to inflationary pressure, not inflation itself. Central banks could choose to put a lid on the pressure by raising interest rates, they say.
One way or the other, though, the changing demographic picture is likely to endanger today's low, low interest rates if the linkage that the researchers has discovered holds true.
They don't spell out the consequences of higher rates, but it's safe to assume that the initial effects would be painful for today's investors. Higher rates would push down bond prices and probably real estate values and stock prices as well.
Of course, as the researchers note, long-run economic projections have a horrible track record. So you may not want to base your portfolio strategy on higher interest rates. Just be aware that, contrary to conventional wisdom, an aging population may actually encourage inflation.