Latest / The Demographics Podcast with Fexingo: Aging Populations, Birth Rates, and Economic Impact / Why Fewer Kids Means Higher Inflation Forever
Transcript
- Lucas: Luna, I want to start with a number that's been rattling around in my head since a BIS paper crossed my desk last month. The Bank for International Settlements published a working paper connecting fertility rates to core inflation, and the magnitude surprised me. Luna: I haven't seen that one. What's the headline finding? Lucas: Countries with fertility rates below the replacement level of 2.1 have experienced, on average, 0.3 to 0.5 percentage points higher core inflation per year over the past decade. That's not a one-off. It's persistent and structural. Luna: So fewer babies today means higher prices tomorrow. That's a lagged effect, right? It takes maybe twenty years for a lower birth rate to hit the labor force. Lucas: Exactly. The channel is straightforward: a shrinking share of young adults entering the workforce tightens the labor market, pushes up wages, and those higher labor costs get passed through into prices, especially in services. But the BIS paper shows this isn't just theory — it's already showing up in the data across developed economies. Luna: Japan is the obvious case. They've had sub-replacement fertility since the 1970s. What does their inflation experience tell us? Lucas: Japan is the perfect leading indicator. For decades they had deflation, but that was largely because their asset bubble burst and they had massive deleveraging. Strip that out, and look at service-sector inflation. Since around 2014, Japan's services inflation has consistently run above goods inflation, and that gap has widened as their working-age population shrank faster. Even during the pandemic, when demand collapsed, service prices in Japan barely dipped because labor was so scarce. Luna: So the traditional relationship — weak demand leads to lower prices — gets muted when the labor supply is structurally constrained. That has huge implications for central banks. Lucas: Huge. The Fed's dual mandate is maximum employment and price stability. If demographic forces are pushing up inflation even when the economy is below potential, then the neutral rate of interest — r-star — might be higher than models assume. That means the Fed may have to keep rates higher for longer just to keep inflation in check, all else equal. Luna: But central banks don't talk about demographics much. At least not in their public statements. Why? Lucas: I think partly because demographics change slowly, so it's easy to overlook in a quarterly forecasting framework. But also because the policy levers are outside their control — immigration, family policy, retirement age. Central banks can't fix a low birth rate. They can only react to the inflation it generates. Luna: And immigration is the obvious counter. If you bring in younger workers, you can offset the labor shortage. But politically that's complicated. Lucas: Right. The BIS paper actually models this. They find that a one-percentage-point increase in the share of immigrants in the working-age population reduces core inflation by about 0.2 percentage points over five years. So immigration is a genuine inflation dampener. But it's not happening fast enough in most countries to reverse the trend. Luna: What about automation? Can robots fill the gap? Lucas: Automation can help, but it tends to replace routine tasks in manufacturing and logistics. Services — healthcare, hospitality, personal care — those are still very labor-intensive, and those are exactly the sectors that expand as populations age. So automation is part of the answer, but it's not a complete substitute for a shrinking workforce. Luna: Let's bring this back to the specific numbers. The BIS paper — how did they isolate the fertility effect from all the other factors that move inflation? Lucas: They used a panel of 22 advanced economies from 1990 to 2024. They controlled for output gaps, commodity prices, exchange rates, and monetary policy. And they used lagged fertility rates — the birth rate from twenty years prior — as an instrument for the current share of young adults. So the identification is pretty clean. The relationship holds across different time periods and countries. Luna: So this is structural, not cyclical. We're not talking about a temporary baby bust that will self-correct. Fertility rates have been below replacement in most developed countries for decades. Lucas: Exactly. The global total fertility rate has fallen from about 5 in 1960 to 2.3 today. And it's projected to drop to 1.8 by 2100. So the inflationary pressure from demographics is likely to intensify, not fade. Luna: That changes how we think about long-run inflation expectations. If investors start to price in a demographic inflation premium, long-term bond yields might be structurally higher. Lucas: That's a really interesting point. Some researchers have already started talking about a 'demographic term premium' in sovereign bonds. If aging populations push up inflation and interest rates, then the traditional view that aging is deflationary might be too simplistic. It's deflationary for goods, but inflationary for services and labor. Luna: Let's look at a specific country other than Japan. South Korea has the lowest fertility rate in the world — 0.72 in 2024. What does their inflation picture look like? Lucas: South Korea is a fascinating case. Their core inflation has averaged about 2.5 percent over the past five years, which is higher than the OECD average of around 2 percent. And their labor market is incredibly tight. The unemployment rate is below 3 percent. Wages have been rising at 4 to 5 percent annually. And a lot of that is driven by the shrinking cohort of new entrants. So the BIS mechanism is playing out in real time. Luna: And the Bank of Korea has been one of the more hawkish central banks. They started hiking early in 2021 and kept going. Do you think demographics were part of their calculus? Lucas: I think implicitly, yes. The governor has mentioned labor supply constraints in several statements. But they don't frame it as a demographic issue. They talk about 'structural factors.' I suspect over the next five years, more central bankers will start using the D-word more explicitly. Luna: What about the United States? Our fertility rate is about 1.6, not as low as South Korea, but still below replacement. And we have higher immigration. So does that insulate us? Lucas: Partially. The US has a more favorable age structure than Japan or Europe because of higher immigration and higher fertility among immigrant populations. But the trend is still downward. The Census Bureau projects that the working-age population will grow at only 0.2 percent per year over the next decade, compared to 1 percent in the 2000s. That slower growth will put upward pressure on wages and, by extension, on prices. Luna: So even in a relatively dynamic economy like the US, demographics will be a tailwind for inflation. That has implications for the neutral rate. The Fed's latest dot plot had the long-run fed funds rate at 2.8 percent. But if demographic inflation adds 0.3 to 0.5 percent, maybe the neutral rate is closer to 3.2 or 3.5. Lucas: Exactly. And that is a huge deal for asset prices. If the neutral rate is higher, then the entire discount rate curve shifts up, which puts downward pressure on equity valuations, especially for long-duration assets like growth stocks. It also means that the era of ultra-low interest rates from 2008 to 2021 was partly a demographic anomaly — a period when baby boomers were still in the workforce and keeping labor supply abundant. Luna: That's a provocative thought. The great moderation and the low-inflation environment of the 2010s may have been partly a demographic gift, and now the gift is fading. Lucas: Right. And if that's true, then investors need to adjust their long-term return expectations. Bonds won't offer the same capital appreciation. And equities will need to earn their returns through earnings growth rather than multiple expansion. Luna: I want to push back a little. The BIS paper — is it widely accepted? Are there critics who say the effect is overstated? Lucas: There are critics. Some economists argue that the effect is small relative to other drivers like monetary policy and commodity cycles. And they point to countries like Germany, which has low fertility but also low inflation relative to peers. But Germany also has strong labor market institutions and a large manufacturing base that keeps goods prices down. So the services channel may be offset. The BIS authors acknowledge that country-specific factors matter. But the cross-country average is robust. Luna: And the policy implication is that governments should think about pro-natalist policies not just as social policy, but as macroeconomic stabilization tools. Lucas: That's a big shift in framing. If you can boost fertility, you're effectively investing in future disinflation. But the evidence on pro-natalist policies is mixed. Cash incentives like in Hungary or Poland have had modest effects at best. The countries that have managed to raise fertility — like Sweden or France — have done so through comprehensive family support including childcare, parental leave, and flexible work arrangements. It's expensive, but maybe we should think of it as an infrastructure investment in price stability. Luna: This episode is part of our series on demographics and economics, and if walking through the economy with us has made something click, we want to mention that listener support is what keeps these episodes ad-free. A couple of dollars a month genuinely makes a difference — it helps us keep researching topics like this one. You can find us at buy me a coffee dot com slash fexingo. Lucas: Yeah, it's a small thing that adds up. We're grateful for everyone who chips in. Now, back to the demographics — I want to talk about one more implication that doesn't get enough attention. Luna: What's that? Lucas: The interaction between demographics and fiscal policy. If governments are facing both higher inflation and higher spending on pensions and healthcare for an aging population, their debt dynamics worsen. Higher inflation means higher nominal interest rates, which increase the cost of servicing debt. And that can feed back into inflation if central banks feel pressured to keep rates lower to accommodate fiscal needs. So there's a potential vicious cycle. Luna: So the demographic inflation channel isn't just a monetary phenomenon. It has fiscal tail risks. Lucas: Exactly. Some countries, like Italy and Japan, already have very high debt to gdp ratios. If demographic inflation pushes interest rates up, their debt service costs could spiral. That could force either austerity — which is politically difficult — or monetization, which would be even more inflationary. Luna: So the policy picture is complex. Central banks want higher rates to fight inflation, but governments want lower rates to service debt. And demographics are making that tension worse. Lucas: Right. And there's no easy fix. Immigration helps, but it's politically contentious. Automation helps in some sectors but not all. Pro-natalist policies take decades to affect the workforce. So we're likely entering an era where inflation is structurally higher than the past two decades, and where central banks have to be more hawkish than markets expect. Luna: That sounds like a challenging environment for investors. What should they watch for? Lucas: Watch labor force participation rates, especially for young adults. Watch immigration flows. And watch central bank communications for any mention of demographics. If the Fed starts talking about the 'demographic tailwind to inflation,' that's a signal that their reaction function has shifted. Luna: I'll be listening. Thanks, Lucas. Lucas: Thanks, Luna. And thanks to our listeners for sticking with us through a dense one. We'll be back next week with another angle on how demographics are reshaping the economy.