Maybe you have a similar question that I recently received from a client: 

"With Jeff Bezos challenging his competitors to raise the wages of their employees and Jamie Diamond saying capitalism is not working for the little people, does this mean that inflation will begin to rear its head soon? Or do you still think deflation is the bigger risk?"

Slowing Growth, Lower Inflation

There are many factors that can have a short-term effect on inflation and interest rates, such as the Federal Reserve increasing the overnight lending rate, or a political disruption in the Middle East affecting oil prices. These are impossible to predict and difficult to trade on effectively.

But over the long-term, economic changes are heavily influenced by changes in the population. Population changes happen slowly, are measured by generation, and are much more predictable. We believe that the current demographic trend is leading to slower economic growth than we have experienced in the past, with lower inflation and lower interest rates expected into the future.

Spending Power by Generation

Generational spending patterns show a lot of consistency with younger people consuming more, and older people consuming less. We’re all living through it. Spending is high when a young adult is just starting out, buying a house, and raising children. Older people tend to spend less, especially when the children are out of the house and they retire. We have an aging population across the developed world — US, Europe, Japan — and in many developing countries too, such as China and Russia. At current birth rates, we will eventually have population decline in the developed world, and in many developing nations as well.

The population of some developing countries is growing faster than the developed world, but even they are growing less fast than in the past.

With fewer people, and considering that older people are a larger part of the whole, this leads to less demand for goods and services. This, in fact, is the main reason that we expect slow economic growth, low interest rates, and low inflation in the long run.

Other Factors Impacting Inflation

In addition to an aging population, other issues leading to slower growth include the following:

1.    High debt load of governments
2.    Spending pattern of younger workers

Regarding government, the tax cuts we received last year — coupled with higher spending — will have to moderate at some point in the future. Tax rates will need to increase and government spending will need to decrease to better balance with tax revenues eventually.

The current inflation rate is moderate at 2 percent, even though we have 1) higher government spending, 2) low unemployment, 3) a Federal Reserve that is keeping rates low, and 4) a Fed that is maintaining a large balance sheet. It is difficult to imagine what more could be done to generate inflation even if we wanted to. 

How Millennials Spend Money Differently

Younger workers have higher student loan debt than prior generations. Their overall debt is about the same as prior generations when they were at the same age, but the debt mix is different.

Prior generations were buying houses earlier and had more of their debt load related to mortgages. House buying is important because it has a more positive ripple effect on the rest of the economy than many other types of spending.

Spending on furniture and home improvements are two positive side effects of purchasing a home. Plus, borrowing to acquire what is hopefully an appreciating asset contributes to building wealth over time.

Borrowing money for an education can help lead to higher paying jobs, but it is not the same as borrowing to buy a stand-alone asset, like mortgages do. And prior generations were able to acquire higher paying jobs without the size of the student loan debt that millennials are faced with today.

A greater share of the spending by earlier generations was circulated back into the economy. Milton Friedman referred to it as the velocity of money, which refers to how many times money circulates through the system. Money used to pay back student loans just gets returned to the bank.

So many of the positive growth attributes that come from spending by young adults is different than it was in the past, and may be contributing to even slower growth than what could be expected by just an aging population. 

Wages And Inflation

Regarding higher wages, it doesn't seem to be having the same inflationary effect as it has in the past. Perhaps it is due to the wages overseas being moderate and that is where most items we buy are made, so overall pricing of goods has been stable.

Higher wages may also be contributing to paying down debt and increasing savings, so it may not be creating increased demand for goods and services as would normally be expected. The savings rate in the US has been rising since the Financial Crisis in 2008 and the latest number is 7.5% (as a percentage of income).

It was 2.7% in 2005.

Money going into savings is good for the individual but it doesn’t contribute directly to economic growth, which only measures spending. 

Higher wages, higher productivity?

Higher wages may also be offset by higher productivity. Productivity is not directly measured, but it is calculated by taking the size of the GDP and dividing by labor hours. So higher productivity could be keeping inflation lower, but we can only know by looking back rather than know in real-time.

This doesn't mean that some goods and services don't have inflation pressures, but overall there seems to be offsetting factors that are creating stable or deflationary pricing, such that we have low inflation overall.

Perhaps higher wages are just keeping our heads above water, as opposed to fueling higher growth. It doesn’t seem to be having much effect on inflation or interest rates, which is a continued positive sign for the bond market.

At Archer Bay Capital, we believe that money is personal and that you should be armed with the financial education and support you need to manage it effectively. Contact us to learn more about inflation and interest rates, or to set up a consultation today.