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.

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