I’m currently reading an interesting book by a couple of heavy hitters in the world of economics. It is teaching me a lot about the dismal science and adding weight to my view that we are on the cusp of entering a new era of inflation.
The book is called The Great Demographic Reversal by Charles Goodhart and Manoj Pradhan.
Charles Goodhart was a member of the Bank of England’s Monetary Policy Committee from June 1997 to May 2000, and a professor at the London School of Economics from 1985 to 2002, becoming an Emeritus Professor in 2002.
Manoj Pradhan is the founder of independent macroeconomic research firm, Talking Heads Macroeconomics. He was previously Managing Director at Morgan Stanley where he led the ‘Global Economics’ team.
I’m only halfway through the book so I’ll give you another update on it next Tuesday when I should be finished.
But the key points that are piquing my interest are their explanations that inflation isn’t purely a monetary phenomenon.
They believe we are heading towards inflation due to the worldwide shift in demographics that is coming whether we like it or not.
We all know the story of the last few decades. The rise of China flooded the world’s economy with what seemed like a limitless supply of cheap labour. The opening up of Eastern Europe added to the mix, and within a short space of time 400 million workers were vying for jobs in the supply chain that hadn’t been there before.
We were in a demographic sweet spot with the dependency ratio falling. The dependency ratio is a measure of the number of dependents aged zero to 14 and over the age of 65, compared to the total population aged 15 to 64.
The outcome was decades of rising savings and falling inflation as companies shifted production to China. Interest rates plummeted and growth took off.
As you’ve probably guessed from the title of the book, that demographic sweet spot is reversing rapidly worldwide.
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The demographic reversal
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| Source: The Great Demographic Reversal |
Using China as an example, their one child policy lasted from 1979 to 2015. The effects of that policy are now showing up in the shifting dependency ratio which bottomed out around 2010.
If you want a deeper understanding of the opportunities being presented by the changing macroeconomic landscape in China, check out Greg Canavan’s ‘China Divorce’.
The interesting point that Goodhart and Pradhan make is that the demographic reversal is actually inflationary.
With more mouths to feed that aren’t producing anything there is an increase in demand for scarce goods — which is inflationary.
When you have a falling dependency ratio there are more workers producing goods compared to those who need to be supported and it has a dampening effect on inflation.
The effect on savings is another issue that feeds into the view that interest rates will need to rise as the workforce worldwide ages.
A retired worker dissaves as they spend their savings to support themselves. With the dependency ratio turning up there will be an erosion of private sector surplus savings, which has been a cornerstone of the downward pressure on interest rates worldwide for decades.
Ben Bernanke famously referred to this as the ‘savings glut’ in 2005.
Economics 101 teaches us that savings equals investment in a closed economy. The world is a closed economy, so if savings are going to be eroded there will need to be a shift on the investing side of the equation and changing interest rates is the way that equilibrium is usually restored.
Will governments rein in their deficit spending or will the political pressure to continue funding entitlements of an aging population take precedent? I think we all know the answer to that question.
Healthcare costs are going to continue skyrocketing as the population ages also.
We all know that governments are getting more addicted to rising debt levels, and the chance that they will change course anytime soon is fanciful.
The investing landscape for non-financial corporates going forward is a trickier proposition according to Goodhart and Pradhan.
The future won’t look like the past
They point out that as the workforce shrinks, there will be upward pressure on wages as workers regain some pricing power after decades of being price takers.
That shift in the cost structure of businesses will probably inspire capital investment that can increase the productivity of labour.
The long and the short of it is that the future won’t look like the past.
The sharp reversal in demographics that will pick up speed over the next couple of decades is an inflationary impulse that can’t be ignored, and interest rates will have to respond whether the masters of the universe at the US Fed like it or not.
In their own words:
‘Short-term interest rates are determined by official fiat, at least in the short and medium run, whereas longer-term interest rates depend more on market forces.
‘Largely because of the political context which we see unfolding, we think it highly likely that short rates will be held below the increase in inflation which we see developing over the next few decades.
‘In contrast, however, as this new, uncomfortable, world emerges into clearer sight, long rates will start rising and very likely rise above the current rate of inflation. So, one of our conclusions is that the yield curve, which is currently flattened to an unusual degree, will probably steepen sharply.
‘So, we are, in a sense, hedging our bets, suggesting that short rates may continue to run at low real levels, but that longer, e.g. ten-year rates, are likely to show rising real rates.’
With the yield on a 30-year bond in the US currently at 1.35%, it doesn’t take a genius to work out that the path of least resistance is a rise in yields. But there are many who have called an end to the relentless bull market in bonds who have suffered the consequences of going early.
They don’t call going short bonds the widow-maker trade for nothing.
But from what I have read so far, their analysis increases my conviction that we are nearing an inflection point for bonds driven by more than the money printing exploits of the Fed.
Regards,
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Murray Dawes,
For Money Morning
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