In this article I explore how certain demographic risk factors have created structural changes to the U.S. economy that if left unaddressed from a regulatory or policy perspective over the long-term potentially create strong inflationary risks for the economy.
“Investment risk” can be defined as the probability or likelihood of occurrence of losses relative to the expected return on any particular investment. “Inflationary risk” is the risk that inflation will undermine an investment’s returns through a decline in purchasing power. Within the asset class context, while we generally evaluate inflationary risk through the lens of fixed income securities the impact that this risk potentially has on the overall economy cannot be understated and in this first of a three part series, we challenge certain consensus views as it relates to inflation – from how we measure it (e.g. CPI based measurements vs. wage inflation) to the proper time duration to make an informed assessment (1 – 10 years vs. 10 – 50 years) to whether certain structural changes to the world economy have so fundamentally changed the way we should think about this risk (e.g., rise in global national debt rates, structural based declines GDP growth rates, etc.).
Figure 1: Core Personal Consumption Expenditures Price Index, 2017 – 2021
Source: Federal Reserve Bank of St. Louis
While I don’t disagree with the consensus view of inflationary risks over the near or mid-term, I believe the consensus view of inflationary risk over the long-term under-appreciates the impact of certain structural changes to the global economy and how these structural changes may create inflationary pressures that are not being fully appreciated by the market or policymakers. Moreover, I am of the opinion that given the size and complexity of the U.S. economy together with the current size of the U.S. national debt, which as of FY 2020 stood at ~$26.8 trillion and 121% of GDP, we should be measuring these risks over a much longer period of time.
Figure 2: U.S. Total Public Debt to GDP, 1994 – 2020
Source: Federal Reserve Bank of St. Louis
Figure 3: United States Fertility Rate, 1960 – 2018
Source: Federal Reserve Bank of St. Louis
Source: Federal Reserve Bank of St. Louis
Figure 5: Fertility Rate (births per woman), 1960 – 2018
Source: The World Bank
The replacement fertility rate is defined as the level of fertility at which a population exactly replaces itself from one generation to the next. In developed countries this rate is generally accepted as requiring an average of 2.1 children per woman. In 2020, the United States’ replacement fertility rate, together with its low net immigration number, resulted in the country’s lowest population growth rate on record at 0.35%. Large scale declines in the replacement fertility rates are being observed in many of the developed nations and has the potential to severely upend country level productivity in these countries. According to the World Bank, a number of countries including South Korea, Italy and Japan are forecasted to see their populations decline by more than 50% by the end of the century. At first glance, the push-back against any material focus from a regulatory or policy perspective on economic risks that could potentially materialize over coming decades would largely focus on the inability to forecast outcomes out that far or the proverbial approach of policy-making that involves “kicking the can down the road.” However, the problem with this approach within the context of structural risks that take decades to materialize is that they also take decades to correct once the risk actually materializes. Moreover, I believe that these types of structural risks are driven by factors that have the potential to undermine U.S. competitiveness in the near term. For example, the most concerning aspect of this long-term decline in fertility rates that is occurring is that it doesn’t appear to be entirely by choice. Social changes such as female empowerment, the decision to forego children until later years, the mobility of larger numbers of women into the workforce as well as economic constrains have played material roles in this decline. However, scientific evidence also points to a general decline in our overall capacity to have children, as evidenced by a 50% decline in sperm count since 1970 together with an equally rapid increase in the rate of age-adjusted miscarriages. Of these factors, the ones impacting the overall capacity to have children are the most concerning because in addition to having the long-term impact on population growth they also present in the near to mid-term threats to overall competitiveness and without U.S. regulatory and policy-based intervention, these factors could continue to weaken the U.S. competitive standing. The most likely cause of the capacity limitations on child birthing is endocrine disruption, which occurs when the human body is overtaken by environmental toxicants, such as the tens of thousands of artificial organic chemical compounds that we use in our everyday lives (e.g., perfluourinated compounds, bisphenol A, phthalates, etc.).
Although these chemical compounds are utilized globally, the regulatory approach undertaken by the United States presents unique challenges. For example, in the European Union when it comes to the health and safety considerations of chemical compounds the benefit of the doubt is given to human safety. By comparison, in the United States, this analysis usually results in the application of what is referred to as the “Kehoe Paradigm,” which provides that suspicious chemicals should be assumed to be innocent until proven otherwise. This has led to certain perverted results such as lead remaining in petroleum products in the United States for 50 years following when their dangers were first suspected or with respect to the cosmetics industry, the U.S. having banned only 11 substances compared to over 1,000 in the European Union. As the world has continued to advance with more attention paid to bioethical considerations as well as the impact that environmental toxicants have on the human body, I believe that in order to maintain a level of competitiveness it is important that the U.S. start to appreciate the importance of these considerations.
Now returning to our analysis of the long-term impact of lower fertility rates on inflation, the starting point for this analysis is that lower population growth directly results in lower economic growth and also increases the proportion of older adults in the population. For example, in the United States in 1950, 8% of the population was over the age of 65 where that percentage of persons had more than doubled to 16.9% by 2020 and is forecasted to reach 22% by 2050. The percentage of people aged 60 or over in China has risen from 6% of the population in 1970 to 17% by 2021 and is forecasted to reach 35% by 2050. Over time, these trends will result in a decline in worker productivity as well as an increased burden on pension and medical systems as fewer numbers of productive age workers struggle to care for a growing number of retirees. With the elderly consuming a greater percentage of economic resources over time, together with a shortage of young workers requiring more capital spending to maintain productivity, the current era of excess savings is likely to end over the coming decades. This scenario would in all likelihood lead to higher inflation and real interest rates characteristic of the pre-2000 era.
Figure 6: 10-Year Treasury Constant Maturity Rate, 1962 – 2021
Source: Federal Reserve Bank of St. Louis
Source: Macro Trends
Under this scenario, we would most certainly expect that any material rise in inflation and real rates would be accompanied by a reversion towards the lower asset price levels characteristic of the 20th century.
“Bottoms in the investment world don’t end with four-year lows; they end with 10- or 15-year lows.”
~ Jim Rogers
