Aging Raises Cost Of Curbing Inflation

Transcript

We see an aging U.S. population as a key constraint on its workforce now and in the future. That means lower production capacity.

And that means lower growth or persistent inflation over time.

1) Workforce participation problem

The share of people participating in the workforce plummeted in the pandemic.

It has partly recovered, but we don’t see it doing so further because aging accounts for most of the decline since Covid, we find.

A bigger share of the population has reached retirement age, and some workers retired early due to the pandemic.

2) Central banks face sharp trade-off

That means lower production capacity today.

Making for a sharp trade-off for the Federal Reserve: Either create a recession deep enough to get economic activity down to what the economy can sustain…

Or live with persistent inflation.

3) Aging to weigh on growth

Continued aging of the population will weigh on future growth.

If the productivity of each worker keeps increasing at the same rate as before, annual GDP growth would be roughly two-thirds of its average between 1980 and 2020. Now that’s some slow growth!

Here’s our market take…

An aging workforce in the U.S. is a near-term and long-term labor constraint. It’s one reason why we are underweight developed market equities for now and favor inflation-linked bonds.

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The share of the U.S. population in work or seeking a job is still below pre-Covid levels. This shortfall won’t be made up: a bigger share of people are older than the normal retirement age – a major constraint. That makes it hard for the economy to operate at current activity levels without fueling inflation. The Fed would need to crush activity to push inflation back to its target. We see the Fed causing recession, with persistent inflation. We’re underweight stocks and like inflation-linked bonds.

Aging behind workforce decline

Notes: The orange line shows the U.S. labor force participation rate, defined as the share of the adult population (aged 16 and over) that is in work or actively looking for work. The yellow line shows how much the aging population has contributed to the participation rate decline since 2008, as calculated by fixing participation rates and changing the weights based on population data.

A smaller share of the U.S. population is in the workforce than pre-Covid. That’s unlikely to change, we think. Why? The participation rate, or the share of people aged 16 and over that have or are looking for work, nosedived when the pandemic hit and people left the workforce (orange line in chart). Some of that sharp decline has been made up as people return. But we don’t see it recovering further because the effects of an aging population account for most of the remaining shortfall. More people have hit 64 years old, the age at which most retire. That’s taken 1.3 million out of the workforce as of October, we find. Another 630,000 left as the pandemic caused fewer people to work past retirement age and hastened retirement for people coming up to 64. An aging population is increasingly cutting into the participation rate (yellow line) and shrinking the labor force.

These trends explain why the U.S. participation rate is below its pre-Covid level, and yet, unemployment is still at a 50-year low. The share of the population aged over 64 has been increasing since 2010, and it’s set to keep rising. The effect of this demographic shift on participation won’t reverse without massive structural changes in workforce behavior over time, in our view. That implies the workforce will keep shrinking relative to the population. Economic activity will need to run at a lower level to avoid persistent wage and price inflation, especially in the labor-heavy services sector, in our view.

Inflation concerns

Interest rate hikes can’t cure production constraints like labor shortages. So the Fed today faces a sharp trade-off between either creating a recession to slam economic activity down to levels that the economy can more comfortably sustain or living with more persistent inflation. For now, the Fed seems to be trying to do the first, we think, with its “whatever it takes” stance trying to quickly stomp inflation down to its 2% target. In the face of production constraints, bringing inflation down to target would require a deep recession, in our view – a roughly 2% hit to activity. That’s why we think a recession is foretold. Yet, we think the Fed will ultimately stop as the damage from rate hikes becomes clearer and before generating a deep recession. We think that means the U.S. will be in a recession and still living with inflation persistently above target.

An aging population will hurt the U.S. economy’s ability to grow without creating inflation longer term. A lower birth rate may eventually offset some of that effect as household formation and housing demand fall – but only after the costs tied to the aging baby boom generation play out. Demographic trends also suggest the labor pool will expand much more slowly in the next 20 years than it did in the past 20. If individual worker productivity keeps rising at the same rate, annual GDP growth would average just 1.8% – about two-thirds the average from 1980-2020 and the slowest 20-year period since data began.

What this means for investing

We stay overweight inflation-linked bonds because we think inflation will ease up but still be above the Fed’s target for some time. We’re underweight U.S. stocks in the short term because they haven’t fully priced in the recession and corporate earnings downgrades we expect, especially as margin pressures mount from higher wages due in part to labor shortages. We’re also underweight Treasuries – long-term bond yields don’t reflect inflation’s persistence or that investors will demand more compensation for holding them as a result. We instead prefer attractive income in short-end bonds and high-quality credit. Long term, we’re overweight equities and think stocks’ overall return will surpass fixed income.

Market backdrop

U.S. stocks edged higher last week, having rallied 15% from October lows. Long-term U.S. Treasury yields fell, causing the yield curve to invert by the most since the early 1980s. We don’t think stocks are fully pricing in the recession we see from the Fed overtightening policy, even as U.S. PMI data confirmed a deeper contraction in activity. We think the Fed will eventually stop its rate hikes next year, but we’re not expecting the swift rate cuts that the market is pricing in.

We’re watching the U.S. labor market this week, as worker shortages are a key production constraint. Euro area inflation and unemployment data are also important given the European Central Bank’s latest hawkish rhetoric. Inflation remains stubbornly high, so we see the ECB pushing ahead with higher rates even as the economic damage becomes clearer.