Demographic Change, Inflation and Interest Rates

Demographic change, inflation and interest rates

I read it again: demographic change, the demographic ageing of society over the next 15-20 years and a declining proportion of the working-age population will lead to inflation. Two arguments are often put forward in the debate, both with shortcomings.

The first argument is that a shortage of labour increases wages and thus costs for companies. This leads to higher prices. On the one hand, however, this is a real cost push that could lead to a real price push. However, this has nothing to do with a gradual decline in the purchasing power of money, i.e. inflation. Second, the transfer of such a real cost push to real output prices is not perfect: instead of increasing prices, a company can also reduce profits if costs increase or cut costs in other ways, e.g., by substituting away from labour to other factors of production.

The second argument is that older people consume a lot. Therefore, an increase in this population group would increase overall demand. This ignores the fact that the consumption of older people has to be financed. And a large part of this is financed by rising social security contributions from the working population. Their real net income will therefore fall, not rise, despite rising gross wages. There will be no net effect in terms of a boost in demand.

Demographic change reduces growth

On the contrary, demographic change will reduce economic activity. Fewer employees means less production. Net wages and pensions will fall, whether due to rising social security contributions or a falling pension level. The productivity of capital will fall. There will be less innovation. All of this will lead to lower returns on capital and falling real interest rates. These estimates are based on macroeconomic forecasting models that correctly capture the trend decline in real interest rates since 1980. Technical change based on new technologies such as AI will have a cushioning effect. It remains to be seen to what extent, but this will hardly overcompensate for the negative effects.

What about inflation? For the same reason, namely lower dynamics in ageing societies and a no-arbitrage relationship between real returns on capital and nominal returns on government bonds, I expect inflation to be low. Real and nominal interest rates will therefore be low or continue to fall over the next 15 years.