Monday, April 18, 2016

18/4/16: Demographics, Ageing & Inflation

In my Investment Theory & ESG Risk course, a week ago, we were looking at Asset Price Models extensions to incorporate inflation risks. One discussion we had was about the possible correlation between inflation and investor behaviour / choices, linked to behavioural anomalies.

A recent Bank of Finland working paper by Mikael Juselius and Elod Takats, titled “The Age-Structure – Inflation Puzzle” (2016, Bank of Finland Research Discussion Paper No. 4/2016: sheds some light on this link via demographic side of investor / economic agent impact on inflationary expectations.

Specifically, the authors uncovered “a puzzling link between low-frequency inflation and the population age-structure”.

This link is pretty simple: due to asymmetric relationship between consumption, savings and investment across the life cycle, “the young and old (dependents) are inflationary whereas the working age population is disinflationary”.

In other words, risks of higher inflation are demographically tilted against markets / economies with either high young age dependencies, old age dependencies or both.

According to authors, “the relationship is not spurious and holds for different specifications and controls in data from 22 advanced economies from 1955 to 2014.”

And effects are large: “The age-structure effect is economically sizable, accounting e.g. for about 6.5 percentage points of U.S. disinflation from 1975 to today’s low inflation environment. It also accounts for much of inflation persistence, which challenges traditional narratives of trend inflation.”

Crucially, “the age-structure effect is forecastable” in so far as we can see pretty accurately long term demographic trends, “and will increase inflationary pressures over the coming decades”. In other words, deflationary environment today is expected to become inflationary environment tomorrow:

Hence, the rising demand for real assets and structural support for new levels of gold prices.

It’s all in the long run game.

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