By Patrick Imam
Patrick Imam explores how a population with an ageing demographic requires certain monetary policy in order to be effective in the post-crisis era. Factors that will need to be taken into consideration, he argues, include the structural transformation in the credit market, and changes in the way monetary policy affects the expectations of businesses and consumers.
Rising life expectancy rates – thanks to mounting living standards and the application of new technologies – is arguably one of the most remarkable achievements of modern times. Over the last decades, gains in longevity of about two years per decade in advanced economies have been the norm, and there is no inflection in the trend in sight.1 As a result, the world is going through an unprecedented demographic transition.
Successfully managing this structural change is a major challenge for policymakers who are going forward. The consequences of a graying population for government spending and taxation policy has been widely explored and generally agreed upon: a combination of higher taxes; reduced pension benefits; and longer working lives is essential to dealing with the fiscal burden an ageing population imposes – although the political challenges of doing so are enormous.
There has, however, been little exploration of the impact of an ageing population regarding monetary policy; policy involving the process by which authorities influence interest rates to promote stable inflation, employment, and growth.
The limited investigation, by the economic profession, on the impact of graying on monetary policy effectiveness is surprising. This is because the life-cycle hypothesis — which posits that households mainly borrow when they are young, accumulate assets and pay down their loans until they retire, then live off their assets in retirement — suggests a clear link between the effectiveness of monetary policy, and the phase in life of a household. Part of the reason economists have barely explored that link is because monetary policy is typically designed to react, over a short time horizon of one to two years, to short-term shocks, rather than to the slow-moving factors, such as demographic change, which materialise over decades.
Silent and sluggish though demographic change may be, Imam shows that there are significant implications for monetary policy in advanced economies – notably on current unconventional approaches such as quantitative easing that those economies have deployed in recent years.2 Theoretically, the impact is ambiguous: older populations are affected in different ways by different monetary policy channels and instruments. On balance, though, Imam finds that a graying society blunts the effectiveness of monetary policy.
Monetary policy was accorded much of the credit for containing and stabilising inflation, thereby fostering the steady growth and major reduction in business cycle volatility that lasted in advanced economies from the mid-1980s until the global financial crisis that began in 2008. By containing inflationary expectations, the analysis has it, central banks reduced the uncertainty that clouds investment decisions and holds back consumption, and were able to respond flexibly to unforeseen shocks. The quick monetary easing following the Internet bubble in 2000, for instance, was possible from this viewpoint because inflation expectations were in check.
But belief in the effectiveness of monetary policy was upended by the 2008 global financial crisis. Since then, central banks have found it difficult to prop up growth and prices – whether in Japan, the United States, or Europe. Now, mounting evidence demonstrates that even during the roughly twenty-five years or so of the so-called “Great Moderation” that preceded the crisis, monetary policy was less omnipotent than it appeared.
This new evidence shows that monetary policy has had a diminished, and diminishing, impact on variables such as unemployment and inflation since the mid-1980s. Boivin, Kiley, and Mishkin summarised recent findings showing that changes in the behaviour of monetary policy in developed countries have anchored expectations more successfully, and have significantly changed the transmission of shocks to economic activity and inflation.3 Inflation is generally less responsive to changes in the cyclical unemployment-output gap, in cases where inflation expectations remain well-anchored on the central bank’s inflation target, including during deep recessions such as the global financial crisis, consequently reducing the impact of interest rate changes.4
Researchers have two main explanations for the reduced effects of monetary policy:
• Structural transformation in the credit market: As regulatory restrictions were gradually loosened and credit markets liberalised, new forms of lending (such as securitisation) have allowed more types of institutions to provide credit through so called “shadow banks”. These allow for easier access to credit, and permit a greater amount of credit to be accessed by a part of the population that had been credit-constrained – especially those on lower incomes. These changes should, in principle, increase the effectiveness of monetary policy. The changes in credit markets, however, occurred at the same time that household balance sheets – especially the value of houses – began to play a growing role in consumption decisions, with consumers tapping the equity in their homes by refinancing their mortgages. That meant that standard consumer borrowing and interest rates became less important, which in turn reduced the importance of the credit channel and the sensitivity of economic activity to monetary policy changes.
• Changes in the way monetary policy affects the expectations of businesses and consumers: Some economists also argued that central banks — because of their strong credibility — have increasingly operated through “open mouth operations” — that is, managing expectations through communications alone — without having to change interest rates as much as they did before. The expectation that monetary policy would, due to its potential, respond strongly to deviations of output, or to deviations from the inflation target, has consequently led to more stability in expectations for inflation. This leads to greater stability in actual spending and inflation, which reduces the effect of interest rate changes.
Many economists argue that these factors explain why the unprecedented monetary policy expansion since 2008 has not had a larger impact on inflation or output. These factors are important, but they are not the only explanation for the decreased effectiveness of monetary policy. One explanation which has not garnered much attention is the fact that there has been changing demographics, something which has also played an important role in weakening the effectiveness of monetary policy in five major advanced economies studied (the US, UK, Japan, Canada, Germany). Demographics has, in other words, played a role – alongside structural change and expectations – in moderating the effect of monetary policy on inflation and unemployment.
Demographic profiles vary significantly by country. Some, such as Germany and Japan, are ageing more rapidly than others, but no country remains untouched by this phenomenon. The result is a growing ratio of the elderly to the working age population. Because fertility rates are plummeting everywhere, the world is rapidly graying (see Figure 1).
Based on the life-cycle hypothesis, older societies should have a large share of households that are creditors, and be less sensitive to interest rate changes; particularly if interest rates are fixed, as is usually the case for most older households in the countries looked into. In the meantime, younger societies should have a larger share of debtors that have higher sensitivity to changes in interest rates induced by monetary policy. A caveat is, of course, if younger households are credit-constrained, in which case their sensitivity to interest rate changes would initially be less important.
Channels through which Demographic Change Impacts Monetary Policy
Monetary policy affects different groups in varying ways. Among the ways through which monetary policy induces changes in behaviour by adjusting interest rates are:
• The Interest Rate Channel: According to the life-cycle hypothesis, individuals acquire assets such as houses and stocks throughout their working lives, and sell them after they retire. Both the savings and consumption patterns of households therefore follow a well-established path that changes with age. Debt levels rise early in life, and then begin to fall (although in recent years, the fall may have been more gradual than in the past, given the global crisis – with the increasing number of those caring for elderly parents, etc. – which makes saving harder). Young households, which are typically net debtors, are more sensitive to interest rate changes, while older households – which typically do not need to borrow – are less sensitive to this channel. That means that in societies dominated by young households, monetary policy would be a more effective tool for dampening or encouraging demand than it would be in an older society.
• The Credit Channel: This channel amplifies the interest rate channel by affecting the so-called “external finance premium”: the difference in the cost to households, or businesses, of using their own funds to finance purchases rather than borrowing externally. Older households have greater net worth than younger households, and are more likely to rely on self-financing to fund investment or consumption. At the same time, older individuals have a large amount of assets that can be used as collateral, so the risk-premium of borrowing, and the cost of raising external funds, should also be lower. This makes grayer societies less sensitive to the effect of monetary policy on the credit channel. There are many older people in poverty in advanced economies, but they are normally affected only to a small extent by monetary policy changes, because they cannot obtain credit under any circumstances.
• The Wealth Effect Channel: Based on the life-cycle hypothesis, demographic shifts can be expected to affect asset prices. Young people typically have few assets, while older people may own many. When a household has acquired substantial assets, many of them are interest-earning. This means that interest rate changes have a bigger impact on older households income than they do on households with few interest-earning assets. In graying societies, wealth effects would become more important, because wealth tends to be concentrated among the elderly (in advanced economies) and such wealth is typically more heavily invested in interest-sensitive fixed-income products (such as bank deposits or bonds) rather than equities. The demographic shift would, therefore, tend to raise the relative importance of the wealth effect channel, increasing the effectiveness of monetary policy.5
• The Risk-taking Channel: While less studied and more difficult to discern, monetary policy affects the perception of risk by individuals and firms. This channel of monetary policy influences risk-taking by encouraging the “search for yield.” Financial entities have been found to take on more leverage when interest rates fall (and less when interest rates rise). Older individuals have less time to recoup losses than do younger people, so in an older society there may be more risk-averse households and, as a consequence, less overall risk-taking; notably in equities versus bonds. Because the risk-taking channel is likely to be less potent in a graying society, monetary policy effectiveness should be diminished.
To estimate the net impact of these conflicting effects of demographic changes on monetary policy effectiveness, Imam mapped the results of the estimations of each country’s monetary policy against its demographic structure.6 The research focused on the five biggest advanced economies that have had independent monetary policies over the period of 1963 to 2007 — Canada, Germany, Japan, the UK, and the US — in order to avoid any bias of the estimation driven by the global financial crisis. Changes in monetary policy effectiveness were compared with changes in the old-age dependency ratios in each of the five countries, focusing on the extent to which ageing can explain changes in interest rate sensitivity. This means that an analysis of the impact of changes in monetary policy on inflation and unemployment was performed. The research confirmed a robust relationship between the demographic trend and monetary policy effectiveness.
The research also showed that one reason ageing affects monetary policy is through the long-term graying of the population, not just through short-term factors like the business cycle. The results indicate that a 1 percentage-point increase in the old-age dependency ratio lessens the ability of monetary policy to affect inflation by 0.1 percentage points, and its ability to affect the jobless rate by 0.35 percentage points. This is particularly significant when linked to, for instance, the projected 10 percentage-point rise in the old-age dependency ratio in Germany over the next decade. In societies dominated by older folks, therefore, the decreased effectiveness of monetary policy is more marked.
Policy Implications for Monetary Policy
Demographic shift is part of the explanation for why monetary stimulus is not having a larger impact. If societies dominated by older households tend to be less sensitive to interest rate changes, then monetary policy will be less potent. Demographics will also mean that policy rates will remain low in advanced economies for a long time (unless, for instance, asset values fall to make younger households feel richer relative to retirees). New tradeoffs will arise in a society going through the demographic shift, tradeoffs that will be likely to cause monetary policy to operate differently in order to achieve the same impact.
The relative preference for inflation versus output stabilisation is likely to change, as older households have, on average, larger asset holdings and, therefore, have more to lose from unexpected inflation. Increasing aversion to inflation may then lead to a lower optimal inflation target. Central banks around the world will have to think through these trade-offs, and may conduct tighter monetary policies in order to keep inflation low, potentially at the expense of more variation in output — in other words, there may be lower inflation, but more recessions and recoveries. Furthermore, if monetary policy is less effective in a graying society, then in order to have the same impact on inflation or unemployment that they had in a younger society, central banks will have to induce a larger change in the interest rate they use to transmit policy. This demonstrates that changes of 25 basis points, which have been the norm in previous decades, may have to get bigger (or, in the current environment characterised in most advanced economies by the zero-bound, aggressive quantitative easing policies, will instead become part of the normal tool-kit and used more frequently). Monetary policy will have to become more activist in ageing societies, with bigger variations in interest rates to enhance their effectiveness.
In addition, the declining effectiveness of monetary policy will also enhance the importance of non-monetary policies, such as taxing and spending, when it comes to stabilising the economy and financial system. So-called “macro-prudential” policies may also play a greater role in enhancing monetary policy. Macro-prudential policies use financial regulatory prudential tools — such as mandating bank loan-to-value ratios, and capital requirements — to address concerns about the overall economy. For example, if the transmission of monetary policy appears clogged, one way to induce (or dampen) borrowing or lending is to alter those prudential ratios, without compromising financial stability.
N.B: This article is based on Patrick Imam’s 2013 published work. The views expressed reflect those of the author, and do not necessarily reflect those of the IMF or IMF policy.
About the Author
Patrick Imam is a senior economist in the Monetary and Capital Markets department of the IMF. He has worked in the Western Hemisphere, Asia and Africa, and his research interest encompasses financial market development and financial stability. He holds a PhD in economics from the University of Cambridge.
1. IMF (2012), “The Financial Impact of Longevity Risk”, Global Financial Stability Report, April 2012 (Washington DC: IMF).
2. Imam, P. (2013), “Demographic Shift and the Financial Sector Stability: The Case of Japan” Journal of Population Ageing, Vol. 6 (4), pp. 269-303.
“Shock from Graying: Is the Demographic Shift Weakening Monetary Policy Effectiveness”, IMF Working Paper No. 191 (Washington DC: IMF).
3. Boivin, Jean, Michael Kiley, and Frederic Mishkin (2010), “How Has the Monetary Transmission Mechanism Evolved Over Time?”, NBER Working Paper No. 15879 (National Bureau of Economic Research: Cambridge, Massachusetts).
4. IMF (2013), “The Dog that Didn’t Bark: Has Inflation been Muzzled or Was It Just Sleeping?”, World Economic Outlook, (Washington DC: IMF), April, Chapter 3, pp. 1-17.
5. Since the global crisis, even the wealth effect channel may in fact have weakened monetary policy effectiveness. By reducing the income that can be generated from savings or through an annuity, looser monetary policy may have encouraged older households to save more, assuming the income effect dominates the consumption effect – hence QE has a large drag on consumption as it props up asset values. However, convincing empirical evidence for this effect is not yet available.
6. Imam, 2013