Do ageing populations mean higher inflation is here to stay?

Fewer people in the workforce will impact prospects for both spending and production

March 30, 2022
  • David Rea

Inflation across much of Europe is at a three-decade high, driven up by the rapid economic rebound from the pandemic and the impact of the geopolitical situation in eastern Europe. These pressures may last months, or perhaps longer, but will eventually fade and leave inflation dependent on economic fundamentals and demographics.

Over the rest of this decade, Europe will see the largest change in its working age population since the 1980s. But in the opposite direction, 20 million people are expected to retire and leave the labour force.

There is an argument that a decreasing workforce will mean more inflation, as our productive capacity declines – from fewer people producing – while spending continues to grow as retirees draw down their pensions.

It’s a good argument. But so is the counter view, and that’s where we stand. The argument comes down to the prospects for both the spending and production sides of the economy.

On the spending side, a shrinking workforce and more people in retirement will mean less disposable income: retired people have less cash than working people of the same age. The retired tend to spend less than younger people: more cruises, but fewer clothes purchases, less going out, and no or little outlay on rent or mortgages. So aggregate demand and spend takes a hit.

The ability to borrow and take on debt complicates the story a bit, as debt essentially funds greater consumption, which could prop up demand. But if we assume debt will be repaid, we can set this aside.

In some economies, those people still in work may also have a greater tax burden to support care and benefits for the elderly. This cuts the take home pay for those in work. The net effect is lower aggregate demand and less spending. This lack of demand should be deflationary – but this is only half the story.

Slower growth in productivity

On the production side, it’s a bit more complicated because of the ability to outsource production and buy imports. Domestically, a shrinking population will mean fewer people in work, which could reduce production or limit production growth. If nothing else, it’s likely to cause a shift away from labour to technology.

At the same time, falling demand will dis-incentivise investment into increasing future capacity - justified when the market is growing, but not when it’s shrinking. This reduces investment, which will mean less demand, slower growth in productivity and the supply side of the economy, and less need for savings to fund investment.

This means that supply side growth will fall, which could be inflationary.

The answer to the question of whether an ageing population is inflationary or deflationary then comes down to the balance of supply side growth and demand side growth – and that’s the same question that central bankers are wrestling with today over the near-term inflation outlook.

In Japan, huge government borrowing supports aggregate consumption, but household spending is falling. Businesses continue to invest because they can access global markets, but much of this investment has been overseas, which has been disinflationary domestically. This leaves Japan with high services costs and, relatively speaking, low goods costs. On balance, Japan’s ageing population and shrinking workforce is deflationary, though other factors are also at play.

It’s a complicated and finely tuned picture, but the economic consensus – for now at least – is that an ageing population will be deflationary.