A look at inflation from First Principles
Was it the war in Ukraine, the pandemic, or something else?
TL;DR Inflation is not only driven by the war and recent pandemic, but also perhaps by demographic changes in the US economy. We are essentially lapping the boomers in the US.
The relationship between population growth and economic growth
I came across this interesting paper (Peterson 2017) while reading about Piketty’s Capital in the 21st century investigating the relationship between population and economic output, something that has been in the news lately due to Elon Musk claiming that underpopulation was a threat to the world.
Oh boy, where do we even start with this one? It seems that the relationship between economic growth and population growth is a hot topic among economists, with some saying more people means more growth and others saying it's a drag on the economy. Apparently, the data from 1990 to 2015 showed no real correlation between the two. It looks like population growth can be good for economic growth in poorer countries because it leads to a "demographic dividend" as young people enter the workforce, but it can also be bad in the short term if it's driven by high fertility rates. In richer countries, population growth is usually low or negative, which can cause problems for social security systems, however, migration from poorer to richer countries can help with this. Finally, some people think the world is overpopulated and we need to reduce the population, while others think technology and market forces will save us from resource shortages and environmental disasters. Ultimately, the relationship between economic growth and population growth depends on factors such as productivity changes and resource availability, but it seems logical to me that at the moment labor is certainly a factor in output.
Trying to understand US demand using population data
I imagine the top word in the news this year was ‘inflation’ as the highest CPI numbers in my lifetime ravaged economies and the market. While many politicians pointed to the war in Ukraine, or lingering supply chain issues related to the pandemic, I thought it would be worthwhile to take a first principles perspective using data from the fed to see if there was any correlation between population growth and the markets (which are proportional to expected earnings per share). While I’m hesitant to draw conclusions, it’s still an interesting directional exercise.
The bureau of labor statistics has a wonderful consumer expenditure by age paper which shows a clear trend: Young people forming households and having/raising children between the ages of 35 and 54 are peak earners and peaks spenders:
Although this data is from 2013, I’ve assumed for the sake of this analysis that the distribution hasn’t changed over time and indexed expenditures to account for inflation:
I then pulled S&P Historical data from Macrotrends and population data and projections from the UN. I looked at 10 year CAGR returns on the S&P and plotted those returns against the rate of change of 30-45 year olds, the results are fairly interesting.
A story of two generations
The red line represents the rate of change of peak spending age Americans (age 30-44) while the blue line shows CAGR of US 10 year returns. What we see is the rate of change of top spenders will peak in 2025 as most millennials will have bought homes and will be well along the journey of raising children by then.
What’s curious is what happened as Gen X rolled in: their population was almost 5 million smaller than the boomers and as ‘family’ aged homes hit a trough in 2009 we had the GFC.
Can we draw any conclusions from this…. no (the analyst in me is screaming correlation isn’t causation) but if there is a relationship between peak spending population and markets it points towards a couple thoughts:
What did the pandemic do to family formation? Did it accelerate it for some and pause it for others? Would this drive a spike then a short trough, then back to the demographic tailwinds we are experiencing?
What will happen towards the end of the next decade as peak spending population drops (I would guess economic headwinds)
Will the economic tailwinds of family formation + population growth combined with our shift to a greener economy (relying on 150+ supply chains for batteries vs <10 for oil) mean that inflation may be here for a while?
I thought it would be interesting to apply those same indexed age/spending distributions to the UN population estimates to give a sense of productivity agnostic economic growth.
This is merely a back of envelope calculation (especially as I assume the age distribution for the EU is the same as the US) and simply serves as an indicator of economic output economic output was only proportional to population age output, in which case clearly Europe might have some problems ahead (even more so China which will see incredible population decline this century!)
Closing thoughts
It’s been a hell of a year for economists. Never in my lifetime (or probably yours!) have we seen money supply (M2) both expand so rapidly (by around $3 Trillion in the pandemic) or shrink at all, nor have we gone through an energy transition similar to what we must go through now, so we are in totally uncharted territories. If there is a meaningful relationship between population changes and economic output then it would make sense to me that Inflation could remain elevated for longer than we expect and potentially become entrenched. I expect the Fed knows this and therefor I do not expect a pivot anytime soon!
Data for this analysis came from FRED and UN population estimates. You can find a working spreadsheet here.