Is inflation really dead?

This decrease in the rate of inflation has been largely a good thing since high inflation brings with it a long list of disadvantages. Most central banks were given mandates in the 80s and 90s to keep inflation at a low level, typically around 2 percent a year, precisely to overcome high inflation. The then-chairman of the US Federal Reserve, Paul Volcker, became known as inflation's number-one enemy when he raised US interest rates to 20 percent in June 1981 to curb price hikes in the United States. In Sweden, the Riksbank was forced to abandon its fixed exchange rate against the ECU (the forerunner of the euro) in autumn 1992, and shortly thereafter the Riksbank's mandate was changed from the fixed exchange rate to achieving price stability, defined as an inflation rate of 2% per year. Since then, inflation has dropped sharply in Sweden.

Graf 1. Inflation Sweden source: Statistics Sweden

Deflation

Central banks have the opposite problem today, with inflation too low for their taste. If we read about the Riksbank's inflation target on its website (Read more here), it argues that falling prices, or deflation, are just as damaging to the economy as overly high inflation. The fear of deflation has pushed most central banks in the developed world into powerful stimulus measures. The US Federal Reserve has kept interest rates at 0 percent since 2009 and has implemented large support purchases of bonds to boost the economy and inflation. The Bank of England has done the same, and the European Central Bank started its major purchase programme of bonds last week. In Sweden, the Riksbank has cut its policy rate to -0.1 percent. But how much can central banks influence the rate of inflation?

Demographics and inflation

The inspiration for this commentary came from a recent article ( Mikael Juselius, Elod Takats. “Can demography affect inflation and monetary policy?” BIS Working Papers No 485, 2015).written by Juselius et al (WP485) and published by the Bank of International Settlements, which examines the relationship between demographics and inflation. The authors of the article question whether the distribution between young people, adults of working age and older people affects inflation and what this impact is.

A common explanation for deflation in Japan has been that the proportion of older people has increased, and when people retire they consume less because they receive less income. This reduces the overall demand for goods and services in the economy and gives rise to deflationary pressures.

When the authors of the BIS article (WP485) analysed the actual data it revealed that the relationship seems to be the reverse. Pensioners do indeed consume less than people of working age, but the dominant effect of retirement is not that they spend less but that they largely stop working. This means that the contribution to the supply of goods and services declines much more when people retire than the contribution to the reduction in demand. This should generate inflationary pressures if anything, not deflationary pressures. The dynamics are similar for children and young people; because they do not work to any great extent they contribute mostly to demand, not supply.

In the article (WP485), the authors compare a couple of different models of how a population's age distribution affects inflation, and some of the results can be seen in the graph below. Both models show that the portion of the population that is of working age contributes to deflation and the remainder contributes to inflation.

Graf 2. Source: Table 1 and Graph 3, WP485

The most interesting observation from the above graph is that the younger group affects inflation just as much as the older group. If we define the younger part of the population as those below 20 and the older part as those over 65, then the dependency ratio from children is the relationship between the proportion of younger people compared with the proportion of working age (20–65) as a percentage. For example, if there is one younger person per person of working age, the dependency ratio from young people is 100 percent, and if there is one older person per two people of working age the dependency ratio from older people is 50 percent.

Below is a graph of the dependency ratio in the USA from 1950 to 2100, with projected numbers according to the UN forecast of moderate fertility.

Graf 3. Source UN population database

The total dependency ratio has been declining in the United States since the 60s as the share of young people in the population has decreased. The proportion of older people has certainly increased, but the decrease in younger people has more than offset this increase. According to the models in WP485, the USA should have had a structural decline in inflation over the past 50 years. Below is a graph showing inflation and the dependency ratio since 1950.

Graf 4. Source UN population database

Apart from the two inflationary peaks in the 1970s, caused by the oil crises, inflation seems to rise when the dependency ratio rises and fall when the dependency ratio falls, just as the models predict.

In recent years, many analysts have concluded that China is exporting deflation to the rest of the world. In a global economy, China's success in exporting cheap goods contributes to both the prices of imported goods and inflation being held down in most developed countries. Below is a graph of the dependency ratio in China.

Graf 5. Source UN database

Apart from the two inflationary peaks in the 1970s, caused by the oil crises, inflation seems to rise when the dependency ratio rises and fall when the dependency ratio falls, just as the models predict.

In recent years, many analysts have concluded that China is exporting deflation to the rest of the world. In a global economy, China's success in exporting cheap goods contributes to both the prices of imported goods and inflation being held down in most developed countries. Below is a graph of the dependency ratio in China.

Graf 6. Source WP485

In Sweden, demographics have lowered the inflation rate by -1.5 percentage points over the past 40 years. Looking ahead, demographics will raise the inflation rate by 2.0 percentage points. In the US, the corresponding figures are -5 percentage points and +2.5 percentage points. In Spain, which has very low birth rates, inflationary pressures will switch from strongly negative to strongly positive.

Since the 2008 financial crisis, the world's central banks have struggled to raise inflation by lowering interest rates to record lows and by stimulating their economies by buying bonds. The price of money is basically zero, and the financial system is filled to the brim with liquidity. All that will be needed to move from low inflation to excessively high inflation is a spark, and the shifting trend from declining dependency ratios to increasing ratios could provide that spark.

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