The great and the good in central banking who will be gathering Aug. 24-Aug. 26 at Jackson Hole, Wyoming, should make sure they read a paper published earlier this month by researchers at the Bank for International Settlements (BIS). It warns that higher inflation finally is coming and central banks had better prepare to normalize monetary policy.
The two authors, Charles Goodhart and Manoj Pradhan, defy the usual view that population aging will cause interest rates to fall as growth slows, and their arguments are compelling. Rather, they say, population aging will cause inflation and interest rates to increase, reversing three big global trends that have lasted for decades.
Demographic developments over the past 35 years have led to falling inflation and wages (and therefore interest rates), rising inequality within countries, and declining inequality between advanced economies and developing ones, the paper argues.
The "demographic sweet spot" started with falling birth rates in advanced economies in the 1970s and 1980s and longevity increasing. Thus, the number of people of working age increased sharply relative to the dependent young and old.
On top of this came the liberation of eastern Europe from communism, which opened this region's working population to the world. A lot of Western factories relocated part or all of their operations there to take advantage of lower wages. China also opened some of its economy to the world, adding to the pool of readily available cheaper workforce.
This development pushed wages down in developed countries (a phenomenon that, some say, led to the Brexit vote in the U.K. and to the victory of Donald Trump in the U.S. presidential election) and raised them in emerging economies, in what effectively was a transfer of income from one category to the other.
China's role is particularly important because, while its labor force joined the global economy, its capital markets did not. With local capital unable to leave the country searching for better yields, Chinese monetary policy was allowed to remain extraordinarily easy for a long time.
On top of that, the lack of adequate state welfare benefits and the "one child" policy meant Chinese people boosted their savings in order to have a cushion for their old age. This outcome created a savings glut, which the Chinese government invested in U.S. Treasury bonds, pushing yields -- which move inversely to bond prices -- down.
But "the sweet spot will now turn sour," the BIS economists wrote in their paper. Global population growth already has fallen, standing at just 1.25% a year, and is expected to decline further to about 0.75% per year by 2040. Developed economies bear the brunt, with population growth halving from more than 1% in the 1950s to below 0.5% now and expected to be flat by 2040.
In this context, the dependency ratio is expected to worsen rapidly. The ratio of workers to the elderly is predicted to steepen for China and Germany starting now and for other countries in the near future.
"The total working-age population in the world, having grown fast between 1970 and 2005, will now grow much less rapidly," according to the BIS paper.
This aging phenomenon will lower both savings and investment, but savings will fall more because older people draw down their savings rather than contribute to them. Just as real interest rates have fallen since the 1980s because of the "demographic sweet spot," they will need to reverse course along with demographic trends.
The countries with current account surpluses (large net savings) such as China and Germany are aging rapidly, while the oil-exporting countries, which also usually have high savings, are likely to see their relative advantage dwindle as alternative energy sources gain ground, the paper notes.
Fewer workers and more dependent people means more consumption overall. Wages will rise because labor scarcity will put employees in a stronger position than they are now. Inflationary pressures therefore will return.
But after years of zero or negative interest rates, "the world is still not ready to think about inflation that is likely to remain with us structurally," the paper warns. "Central banks will, soon enough, have to revert to their normal behavior."
So, it's goodbye global savings glut, hello higher interest rates. Investors beware.