Baumol’s cost disease, aging societies and inflation expectations

Quick hit here.

I have been banging on about lowflation, repeatedly suggesting it is here to stay. The Fed, on the other hand begs to differ and is pre-emptively normalizing rates, as a result. No matter how you look at this, there’s a rub though: We all consume different products, so we each experience a different individual inflation rate.

Even as the statistics say inflation is dropping for you and me, it’s not dropping for everybody. Take our parents, for instance.

Social Security beneficiaries have lost nearly a third of their buying power since 2000 as the costs of items typically purchased by the elderly have significantly outstripped the annual inflation increases in their retirement benefits, according to a new report by The Senior Citizens League (TSCL) obtained by InvestmentNews.


Since 2000, Social Security benefits increased 43% while typical senior expenses, as calculated by The Senior Citizens League’s annual buying power report, have jumped 86%. The survey found that a person having the national average Social Security benefit of $816 per month in 2000 would have $1,169.80 per month by 2016 due to automatic COLA increases in most years. But because retiree costs are rising substantially faster than the COLA, that individual would require a Social Security benefit of $1,517.80 per month in 2017 just to maintain his or her 2000 level of buying power.

“Beneficiaries have just 70% of the buying power they did in 2000, making it more difficult for retirees, particularly those who have been retired the longest, to afford necessities such as medical care, food and housing,” the study found.

“When costs climb more rapidly than benefits, retirees must spend down retirement savings more quickly than expected and those without savings or other retirement income are either going into debt or going without,” Ms. Johnson said.

It’s the going without part that matters for the individuals and for the economy.

I think it’s safe to say that seniors have a higher rate of inflation than you and I do because they consume many of the products like healthcare and prescription drugs where inflation is the highest.

Now, when economics giant William Baumol passed away last month, I posted an ode to him regarding his legendary write-up on inflation in sectors with low productivity growth. The gist is that wages rising across the economy put so much pressure on labour intensive industries that they are forced to pass costs on to consumers. This causes inflation rates in those sectors to be higher, and for these sectors’ share of GDP to increase over time.

I would posit that there are two corollaries here:

  1. In an aging and unequal society, the dispersion of individual inflation rates increases enough to create downward pressure on nominal growth due to people “going without”.
  2. As more people live on fixed incomes as society ages, low rates act as a tax as net interest payments decrease to those with high individual inflation rates.

If you add in the low savings rates in the baby boomer generation, you have a case where the deprivation described in the InvestmentNews article becomes widespread, putting downward pressure on potential nominal growth rates.

Could raising rates help increase inflation via the interest income channel? I think it’s worth considering. If you think about Japan, for example, they have run a zero interest rate policy for decades now. And they are still struggling to get nominal growth rates sustainably higher. At a minimum, I think Japan’s experience points to potential flaws in standard low-rates-stimulative, high-rates-contractionary paradigm.

This is mostly a thought piece since I don’t have the answers – clearly!! But I do want to challenge conventional thinking on inflation, consumption and interest rates. Something has happened in Japan that standard macro really doesn’t explain. And something is now clearly happening in North America and Europe regarding inflation and inflation expectations which is ominous.

I’ll end with this quote from Marc Chandler:

US Treasury yields have fallen around 50 bp since the March rate hike. Market-based measures of inflation, like the 10-year breakeven and the five-year/five years forward, have fallen around 35 bp over the same period. That is to say that the decline in market-based measures of inflation expectations can account for nearly three-quarters of the decline in nominal yields.

That’s not a picture of a booming economy. As well as the US has done economically (and will continue to do, based on my reckoning), the data point to a fundamental shift down in growth. And there are no credible fixes on the horizon. I think Baumol’s cost disease and demographics are a big part of the puzzle.

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