personal views of a former fed trader

One Armed Fed

The Fed’s current focus on inflation over full employment may be a preview of monetary policy in a world where the supply of labor is structurally declining. An aging population implies a persistent decline in the supply of labor, even as demand for labor remains strong because retirees continue to consume. The economic implications of this new regime are previewed through the recent wave of early retirements: lower unemployment, higher wages, higher inflation, and weaker growth. These circumstances reduce the employment costs of tighter policy, potentially changing the Fed’s reaction function by freeing policy to more aggressively target inflation. Recall, the Fed’s mandate is full employment and price stability, not positive economic growth. In this post we review a theory on how aging demographics raise inflation, illustrate its implications with the recent wave of early retirements, and suggest higher interest rates will become structural.

Goodhart’s Theory on Demographic Inflation

Professor Charles Goodhart posited that aging demographics would be inflationary as a decreasing labor supply from retirements would intersect with increasing consumption in old age. He noted that the integration of China and Eastern Europe into global trade amounted to a tremendous surge in the global supply of labor that led to decades of subdued inflation. But that effect would reverse as increasing life expectancies and low birth rates across the world cause the workforce to shrink as a percentage of the population. This can be already be seen in the U.S., where the the prime working age population that steadily increased for decades has now plateaued. An even more dire trend appears in Europe and China, where the prime working age population actually declines sharply.

U.S. demographics. Source: United Nations

Although the supply of labor declines from demographic aging, the demand for labor does not necessarily decline because retirees continue to consume. Retires may purchase fewer cars and houses, but research suggests their overall consumption actually increases due to higher expenditures on healthcare. Note that boomers are wealthy and also receive government transfer payments, so they can finance consumption even without labor income. When a persistent demand for labor meets a declining supply of labor, then wages increase and inflation reemerges.

Per Capita Consumption, Private and Public by Sector, United States, 2000. Source: Lee, Ronald et al. “Charting the Economic Life Cycle.”

Pandemic Case Study

The economic impact of early pandemic retirements offer evidence in favor of Goodhart’s theory. Labor force participation dropped for all age demographics in 2020, but everyone came back to work except the boomer generation. The pandemic appeared to accelerate the retirement decisions of boomers, who may have left the labor force due to health concerns or an improved financial position. This contributed to a shortage in labor, shown by job vacancy rates that are historically high and a labor force today that is actually smaller than it was in early 2020.

Source: “How Many Workers Are Truly “Missing” from the Labor Force?” Didem Tüzemen. FRB Kansas

The shortage of labor has led to a surge in wages and contributed to the broadening of inflation. Wages are growing at the fastest pace in decades, with increases seen in all segments of the labor market. This contributes to cost push price increases because wages are a large expense for many businesses, with non-financial corporations paying $5t in wages in 2020. Higher wages in turn also imply that consumers can afford higher prices, potentially unleashing a wage price spiral.

Source: FRB Atlanta

Secular Stagflation

A declining supply of labor affects the optimal policy response to high inflation or poor economic growth. With respect to inflation, the standard playbook of raising rates to dampen aggregate demand would have less of a negative impact on employment. This opens the door to a more aggressive monetary policy focused largely on price stability.

A declining supply of labor also weakens the link between recession and labor market slack. Recessions could arise simply from increasing retirements leading to fewer workers. The standard playbook of cutting rates would not make sense in that context, as the economy would remain in full employment. In fact, rates would have to be structurally higher to counter the inflationary impact of a steadily shrinking labor supply.


  1. Thomas

    I don’t want to ask a dumb question but if there’s a shortage of labor which results in a shortage of goods and services causing inflation, would causing more unemployment solve this inflation? Wouldn’t it make it worse?

    How does the fed looking at the inflation and going we need more layoffs solve this kind of inflation if it’s coming from a shortage of labor?

    • convexbrah

      Demographics suggest structurally declining participation rates, and mayhaps that translates to hawkish policies (QT+hikes) having a mild effect on employment but a large effect on consumption. So due to ageing demographics, the Fed can be more hawkish than ever before without that unleashing mass unemployment (because boomers were going to retire anyway ).

    • Ben

      My interpretation of this is that interest rates of the last decades are not the norm and we should not expect that to continue.

      The current high Interest rate environment may have some impacts from Covid and stimulus but high interests are part of our future due to demographics.

      • Spencer Bradley Hall

        The decline in rates stems from the decline in the transaction’s velocity of funds. It stems from the Keynesian macro-economic persuasion (the Gurley-Shaw thesis), that banks are credit transmitters instead of credit creators.

        As a greater volume and higher proportion of bank deposits reflect bank-held savings, the slower velocity moves. And the transaction’s velocity of money can move in the opposite direction as income velocity.

        It is axiomatic. Banks don’t lend deposits. Deposits are the result of lending. Bank-held savings have a zero payment’s velocity. Milton Friedman was “one dimensionally” confused.

        Japan is a perfect example. “Japanese households have 52% of their money in currency & deposits, vs 35% for people in the Eurozone and 14% for the US.”

        • Anonymous

          I agree that banks create deposits instead of lending deposits. Can you go into more detail on how Milton Friedman was one dimensionally confused? I work with someone who’s a super libertarian and keeps quoting him and it’s very annoying.

          • Spencer Bradley Hall

            Milton Friedman advocated the complete deregulation of interest rates for banks. He also advocated uniform reserve ratios for banks (December 16, 1959).

            All monetary savings originate in the banks. The source of interest-bearing deposits is other bank deposits, directly or indirectly via the currency route (never more than a seasonal situation), or via the bank’s undivided profits accounts. I.e., the banks, from a system’s perspective, pay for the derivative deposits that they already own.

            The lending capacity of the payment’s system is determined by monetary policy, not by the savings practices of the nonbank public. The commercial banks could continue to lend even if the nonbank public ceased to save altogether. The lending capacity of the payment’s system is a function of the velocity of its deposits, it is not a function of its volume of deposits.

  2. João Pedro Rabaioli Rama

    That’s an intriguing point of vies. The general interest rate playbook is that under that demographics neutral interest rates would fall, though I cannot see where the divergence with your point is coming from.

    • João Pedro Rabaioli Rama

      point of view**

    • Jason

      I’ve read the book on the subject by Goodhart, The Great Demographic Reversal (I highly recommend it), and his view is interest rates are not determined by growth expectations but are governed through the loanable theory of funds. Once the retirees dis-save and global savings go down, interest rates will go up agnostic to the neutral rate of interest.

      • Spencer Bradley Hall

        Good book. Rates are determined by the supply of, and demand for, bank (new money) and nonbank credit (savings). Secular stagnation is simply the deceleration in the velocity of circulation. Secular stagnation produces an excess of savings over real investment outlets.

  3. Lathechuck

    If the supply of money remains constant, shifting demographics will shift the flows of money, but inflation in one area will be balanced by deflation in another area. Aging Boomers may “demand” more health care, but there’s no guarantee that the economy can provide it from current financial assets. If Boomers need to sell real-estate to pay for health care, the value of that real-estate will fall. But, of course, the money supply won’t be constant, so negative real returns will be (continue to be) masked by (taxable) positive nominal returns.

  4. Patrick

    Very interesting. I wonder how automation/technology factors into the declining supply of labor? A few years back it seemed that was a hot topic, and the worry at the time was that many workers would be displaced; driverless trucks causing long haul truckers to be obsolete for example or AI/ML replacing many knowledge workers. Some were saying we’d need to implement UBI to combat the unemployment (there were other arguments for UBI at the time as well).
    Also to the point of structurally higher rates, I’ve heard the argument that the surge in retirees would help keep rates down since they’d likely favor a more conservative allocation in their portfolios and buy more bonds. Haven’t seen analysis around cost of entitlements vs projected deficit and projected incremental buying power of retirees.

    • Jürgen

      Automation shouldn’t be viewed as simply a decline in labor, because it represents labor value itself, albeit in an artificial form that doesn’t need to earn (nearly as many) wages.

      In the context of this article, automation is a good thing because it more or less directly counteracts the negative affects of an aging workforce. It provides a new pool of labor that consumes very little.

      Of course, it needs to come with a wide range of policy reform across many sectors, because an automatic economy works very different to our 20th century economy.

  5. Boomer1

    Labor Participation rate remains in a long term downtrend (even the FEDs manipulated data shows this). I know several highly qualified people that can’t find employment. Their problem is that they are white males over the age of 45…. This article is more propaganda—there is no shortages of labor, but there is way too much Manipulation of the “markets” by the banking cartel and the monopolist FED & FedGov that controls it….

    • Boomer1

      By the way, I know PLENTY of “boomers” that are not wealthy, have very little to no savings, and struggle to keep a roof over their heads.
      Generalizing with a statement like “ Note that boomers are wealthy and also receive government transfer payments, so they can finance consumption even without labor income. ” is highly misleading because it simply does not correspond to the object facts if you consider the vast majority of those being labeled as @boomers”….

  6. Tim B

    Joseph, your argument is compelling. I would bring up one simple counterargument. You are assuming that anyone who retired has made a permanent decision. Persistent inflation and loss of financial asset value could force older people to return to work. There’s also an element to longer life spans that requires people to work longer. Another wild card is productivity increases

    So unless people accept lower standards of living/spending, I don’t see how all early retirees stay that way

    • LT

      There will be no structural labor shortage with the US border open and with waves of refugees escaping the collapsing socialist economies in Latin America created by the USDollar wrecking ball.

      • Spencer Bradley Hall

        But this will aggravate the housing shortage.

        • BenW

          Agreed. I’ve been saying this since Biden took office and flung open the doors.

          It was reported today that, on average, there’s been 55K known got aways each month this FY. Thats 550K since last October. And this is on top of something like 1.5M apprehensions. If this goes on through Biden’s entire first term, we looking at a minimum of 8M undocumented aliens needed housing. Polics aside, that’s ENORMOUS upward pressure on rent.

  7. Siyu

    Sounds like a generational battle is brewing. Boomers want low inflation (i.e. higher unemployment thus low wages) to preserve their retirement life style. Whereas younger workers need higher wages & the ability to build up wealth that is currently captured by the boomers. To make things worse, current decision makers are mostly boomers so they have a vested interested in steering this their way.

  8. BBB++

    Aging demographics is disinflationary NOT inflation. This is being contradicted by this entire article.

    • Thomas

      Lyn Alden made the remake that an aging demographic is disinflationary if you can find another pool of labor to tap into.

      Japan was able to tap into China’s labor base as were we. It’s not so straightforward.

  9. L. Tran

    There are 35 million americans enrolled in Affordable Care Act.
    And they do not need earned income, or need less earned income to get
    the subsidy. For example a spouse on medicare can get ACA for the other spouse,
    or working just one job instead of two jobs.
    I do ot have the numbers, just guessing.

    • Tony

      In order to qualify for ACA an individual needs a minimum income of at least $12,880 in 2022. It gets bigger with family size.

      Subsidy is only up to 400% of Federal Poverty Level (FPL) and that also depends on family size.

      If you go below that income, you qualify for MEDICAID instead.

  10. Deathswap

    fwiw the BIS published a big quantitative study first in 2015 (iirc) and then finalized in 2018 that found that going back to 1870, aging demographics is inflationary. Everyone laughed at them and said it was nonsense, but starting to look good!

    • Tony Frank

      Doesn’t appear to be the case in Japan and China?

    • Joseph Wang

      Cool – thanks!

  11. Katip Abdal

    Wage increases were pretty much concentrated in the lower-earning end of the labor force. If boomers are wealthy, or at least the ones who retired during the Covid crisis are, how would this increase the wage of the unskilled portion of labors? It looks like a coincidence rather than causation to me.
    Also the robust wage growth in lower quartile started at around 2015, although it peaked during the Covid crisis. Labor force participation rates for both the prime age and 65+ rose during 2015-2020.

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