Last month, Janet Yellen, the chairman of the US Federal Reserve ( see picture on the left), admitted in a briefing to the Economic Club of New York that she was baffled by the lack of strong future inflation expectations amongst the American public. I thus thought it was worth sending an open letter to the head of the Fed in order to offer some suggested explanations and solutions.
Dear Janet
You say your baffled by the lack of confidence amongst the American public in the future strength of inflation, despite eight year of the US Federal Reserve’s quantitative easing programmes.
As you of course know, this really matters because if people expect weak inflation in the future, they are going to save rather than spend money. This will lead to disinflationary, or even deflationary, pressures rather than the healthy inflation needed to return the US economy to long term sustainable health.
I think the biggest reason for this critical lack of confidence is demographics. As we say in our new Study:
“Globally, we now have 1bn people moving into the low-spending, low-earning New Old 55-plus generation for the first time in history. They will be more than one in five of the world’s population by 2030, twice the 1950 percentage.
Household consumption is 71% of US GDP, and averages about 60% in the rest of the West, so economic growth is inevitably slowing as the richest, largest and longest-living generation in the history of the world retires in increasing numbers.”
The largest and longest-living generation in history being referred to is obviously the Babyboomers – those who were born between approximately 1946 and 1964.
As the Study also points out, between those years the number of US births jumped by a staggering 51% versus the previous 18 years.
This was mirrored across the rest of the developed world. In the original G7 countries, for instance, which comprised Canada, France, Germany, Italy, Japan, the UK and the US, births rose by 15% in 1946-1970. Why this matters is that the G7 accounted for half of global GDP during this period.
The first sign of the Boomers’ impact came as Western inflation soared in the 1970s, when these babies began to move in big numbers into adulthood.
Inflation rose because the bulge in the adult population meant that there was too much demand for everything from autos to washing machines to housing chasing too little supply. Nobody had anticipated, and so planned for, this imbalance between supply and demand.
As inflation rose, this meant that interest rates had to go up. Globally, they rose by 75% in the 1970s, and then more than doubled during the 1980s. Anybody who grew up during this period will recall only too constant fears about the rising of cost of living and just how expensive it was to borrow money.
In addition, women were joining the workforce in ever greater numbers thanks to a shift in attitudes towards women working. There was also push towards equal pay for both sexes.
So you had a potent combination of a huge number of 25-54 year olds, the biggest number in fact in human history and a boost to disposable income from smaller families and dual-income households.
But the seeds of today’s problems were planted by the fall in fertility rates, which often happens as people get richer. In 2001, the oldest boomers began to join the “New Old” 55-plus generation, and when you get older you spend less as you have most of what you already need.
And then when you retire, spending declines even further as you are living on a pension.
I also worry about the effectiveness of the Fed’s economic stimulus programmes, which has of course comprised several rounds of quantitative easing (QE).
QE reduced interest rates very low levels, whilst also devaluing the US dollar. This forced investors to take their money out of the banks, and out of the greenback, and into equities and commodities in search of higher yields.
I believe that your theory was that higher equity prices would create a “trickle down” effect. But this hasn’t worked because most of middle America’s only involvement in stock markets is via investments made on their behalf by private pension funds.
And the problem with some pension funds is that they are facing major shortfalls because of growing liabilities resulting from ageing populations.
Here is another problem: Commodity prices have collapsed, most notably oil prices, and so pension funds that poured into crude and iron ore etc. are confronting significant losses.
The other problem with QE is that even if there had been some kind of significant trickle-down effect from higher equity prices, it is hard to see how it would have been of a scale big enough to compensate for the demographic headwinds. Because of a lack of young people replacing all the retirees, there are simply not enough working people earning money to replace all of those who are now living on pensions.
The trigger for the recent round of asset-price deflation centred on China, when it became apparent that its economy was going through major reforms. This meant that long term demand growth forecasts for oil, iron ore and other commodities that had justified the run-up in prices were way too optimistic.
And because of the high prices – which in my view were purely the result of financial speculation as investors sought higher yield – companies built vast oversupply in oil, iron ore and a wide range of manufactured goods.
So, in effect, what QE has done has created deflationary, rather than inflationary, pressures to add to the existing deflationary pressures that were always going to be there because of the retirement of the Babyboomers.
I believe there is a fantastic opportunity to fix this. As I said, globally there are 1bn people now joining the 55+ New Old demographic.
Because of improvements in healthcare and diet etc., this generation will live at least 20 years longer than would have been the case in the past. So they do not have to be a drag on economic growth. Just the opposite.
Just imagine the economic growth that would be unlocked if goods and services are increasingly targeted at these groups of people, provided that these goods and services are affordable.
Politically tough decisions are also essential. For example, retirement ages will have to be raised which of course raise the size of working populations.
You could lead the way by getting together with other Western central bankers and with politicians to work on these vital initiatives.
Best Regards
John Richardson