In an interview granted to CFA Magazine, Richard Hockenson, founder of Hockenson & Company, a firm that specializes in research on the impact of demographics on the economy, shares some of his findings. He previously served as chief economist at Donaldson, Lufkin & Jenrette.
Richard Hockenson sees a major change in global demographic trends. The world’s population, which always grew in the past, could be facing a new reality. People nowadays are choosing to have smaller families, as evidenced by the low birth rate in many countries. According to Richard Hockenson, the global population, which is today roughly 6.9 billion, will probably begin to shrink before it gets to 8 billion. A shrinking population presents a whole new set of challenges, both for the economy and for investors.
This type of demographic change translates primarily into falling interest rates over the long term, so we could see a race to zero interest rates. Obviously, this is not a race anyone wants to win. Very low interest rates are good for people who borrow money, but they create a more difficult environment for investors seeking good returns. In a world where inflation is practically nonexistent and where an aging population is increasingly concerned with saving for retirement, nominal rates of return will remain very low. The nominal return on an investment is expressed in constant dollars and does not take inflation into account.
That is Richard Hockenson’s brief explanation of the relationship between demographic trends, economic growth and inflation. If you do a supply-side decomposition of the gross domestic product (GDP), in terms of population, labour force, and productivity, you find a very strong causal relationship between labour force and nominal GDP (in constant, non-inflation-adjusted dollars). Strong labour force growth translates into buoyant GDP growth and, conversely, a shrinking labour force results in GDP contraction. A study on prices in Europe over the past 800 years shows that each period of inflation was preceded, 15 to 20 years earlier, by a rising birth rate. About 15 to 20 years after this rising birth rate, the labour force would see an influx of young workers starting their careers. This wave of young workers would create strong demand in terms of housing, employment and consumption. With supply barely able to keep up with demand, inflation would ensue. At present, global labour force growth is slowing, and the workforce is composed of an aging population, which suggests a possible shrinking of the labour force because workers will not be replaced. In a shrinking labour force scenario, demand contracts more quickly than production can be cut back, resulting in a period of deflation marked by extremely low interest rates.
Richard Hockenson no longer believes in inflation and presumes that since 1981, when interest rates skyrocketed, investors have underestimated the deflationary forces at play. Most investors expect a return of inflation. They think the Fed’s monetary policy will soon have a highly inflationary impact and will push interest rates higher. The population is aging at present and interest rates are extremely low. Inflation is caused either by an increase in the money supply – which Ben Bernanke is now striving for – or by an increase in demand resulting from population growth. Richard Hockenson believes that inflation is above all a demographic phenomenon and that in an aging population context, the risk of high inflation is low, no matter how quickly the Fed pumps money into the system.
So who knows, in the next few years we may be faced with disinflation.