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In the daily quest to identify and predict trends in the market it is easy to forget that the economy is simply a number of people attempting to buy those goods and services which will benefit them. Knowledge of the size and composition of the groups of people within the economy can yield predictive insights. A college student will have different (and predictably different) spending priorities than a business executive, who will, in turn, have different priorities than a retiree.

The predictability comes from the inexorable progression of time. When the distinct categories of people within an economy are known, their needs can be anticipated. This essay attempts to link the size of categories within an economy to predict inflation, and thereby interest rates, based on the spending power of each category.

There are two basic assumptions to be stated at the outset: (1) Inflation is a primary factor, which determines interest rates, and (2) Inflation is a demand-driven phenomenon.

Prices tend to be bid up when a large segment of the population moves into their peak spending years. Expanding markets are created when the large segment replaces the smaller segment, which preceded it. The generations appear in regular 20-year intervals (see Chart 1). The exception is Generation Y, which spans 25 years because members of the Boomer Generation had children later in life.

As detailed in The Age Curve by Kenneth Gronbach, spending power peaks at age 50 and rapidly declines afterwards. In illustration, he listed a 43-year-old male as the best candidate for the purchase of a new car. As my married friends tell me, they need every cent they earn and could put any additional income to use. The demographics are that men marry at an average age of 26 and women at age 25. It is fair to say that the less-structured finances of each individual will become budgeted. The budget then becomes a necessity when the first baby arrives. Family rearing is likely to be a priority, if the couple wishes to have a child, perhaps not more than four or five years after marriage.

Now that we have identified the peak spending years to begin at age 30 and decline after age 50, is it possible to predict a spike in inflation thirty years after a spike in the birthrate? This essay will examine three possible examples of a link between an increased number of people in their peak spending years and an increase in inflation and interest rates.

Chart 1

(click to enlarge)

Gronbach, Kenneth W. The Age Curve: How to Profit from the Coming Demographic Storm. New York: American Management Association, 2008. Print.

Chart 2

(click to enlarge)

AI. "100 Years of Treasury Bond Interest Rate History." Observations. N.p., 17 Nov. 2010. Web. 3 Sept. 2013.

EXAMPLE 1

The number of births rose sharply in the 1930s and was followed, thirty years later, by a spike in interest rates during the 60s (see Chart 2) that lasted for twenty years.

EXAMPLE 2

The number of births declined beginning in the early 1950s and was followed, thirty years later, by a decline in interest rates beginning in the early 1980s that has lasted for thirty years.

EXAMPLE 3

The number of births bottomed in the 70s and rose towards levels achieved in the mid-to-late 50s. The increase from 1970 to 1990 was much less sharp than the increase from 1935 to 1955. Births began to rise after 1975. The expected uptick in spending power thirty years later would have begun after 2005. It was in this period that the housing collapse and recession occurred. Since then, the Federal Reserve has taken unprecedented measures to keep interest rates low. The theory outlined below suggests that inflation will rise on demand from those born after 1975.

The year with the fewest numbers of births during the 1970s was 1973. (There were 3,136,965 according to the Department of Health and Human Services). The year with the greatest number of births to follow was 1990. (There were 4,179,000 according to the Department of Health and Human Services). Note: These numbers were sourced by Pearson Education and the citation for these statistics can be found at the end of the essay.

The theory suggests inflationary pressure beginning in 2003 and lasting through 2020. The year with the fewest number of births achieved during the 1970s (1973) does not mark a definite turn upwards. Births rose in 1974, fell in 1974, and rose in 1976 before making a sustained upward movement. This made the marker for inflation in 2003 ambiguous. The chart reveals 1973 to be the early part of the trough during the 1970s, so inflationary pressure would not rise perceptibly until three years later than expected. This would cause inflation to rise in 2006 instead of 2003. The year 2006 was not long before the housing crash derailed the economy and the Fed intervened to keep rates low.

The year 1990 is a much more fortuitous marker. It makes a clearly defined peak on the chart. Both the year, which preceded it, and the year, which followed it have a lower number of births, as do the years, which preceded and followed those years. The number of thirty-year-olds who were born after 1990 (now age 23) will fall just as the number of those over 47 (born after 1973 and now age 40) increases. That means fewer people entering their peak spending years and more people exiting their peak spending years.

An economy such as China can bid up the cost of raw materials, like copper, in the world market. This had a limited impact on inflation in the United States because inflation, as measured by the Consumer Price Index, is a basket of goods. A material like copper is just one of many goods in the basket. Also, in a truly global market, rising demand from one economy will likely be offset by declining demand in another economy. This helps answer the question as to why commodities, which are priced in U.S. dollars, have had a limited impact on inflation in the U.S. since the year 2000.

In illustration, the soaring price of oil in the 1970s, and the associated inflation, was not from demand in the world market. It was from demand in the U.S. market. The members of OPEC proceeded to charge what the market would bear. Remember the spike in births from 1935 to 1950? Demand for fuel soared when those people entered their peak spending years. Fuel is a large component of the non-core CPI, so it had a big impact on inflation. (Core CPI does not include the cost of food or energy. It is less comprehensive than non-core CPI. The Federal Reserve uses core CPI data in decisions about adjusting the Federal Funds rate. Price swings in food and energy are not included by the Federal Reserve when making the decision because volatility in the commodity markets is considered short-term fluctuation).

In a more complete approach, the theory outlined above would adjust for immigration. This would account for participants in the economy who were not born in the U.S. The additional increase in spending can be controlled for by projecting the annual age distribution of immigrants into the future. For example, immigration of a married couple with both individuals 40 years of age will have the effect of immediate upward pressure in demand. This couple's children, one age 7 and the other age 5, not for some time. It would also be of academic interest to control for immigration in different historical periods. The effect of immigration in periods that saw a great influx of immigrants, such as the World War II era, could be modeled to show the effect on demand and tendency for price inflation.

The theory suggests we should have begun to see inflation, and therefore an increase in interest rates, beginning in 2006. That would have been thirty years after the birthrate bottomed in 1973-1976. The Federal Reserve took the measures of Quantitative Easing and a zero-interest-rate-policy to keep interest rates low. Without these measures it is reasonable to think that interest rates would be higher. From 1976 to the well-defined peak in births in 1990 is fourteen years. This suggests rising inflation until 2020 at which point the oldest members of that segment will be 44 and the youngest will be 30.

In 2020, the number of people entering their 30s will begin to fall. This will be attributed to the decrease in those people born beginning in 1990. The year 2020 will also mark the beginning of an increase in the number of people over 44. This will be attributed to the increase in people born beginning in 1976. Spending will tend to decline because fewer people will enter their 30s and more people will be aging beyond 44. Fewer people in the peak spending period will tend to decrease demand for goods and services.

In conclusion, these findings provide evidence that demographics have a direct impact on interest rates. Bonds are often paired with stocks to diversify investment portfolios. It is for this reason that asset managers usually allocate a portion of each investor's resources to the bond market. Target date funds typically shift assets from stocks (considered volatile) to bonds (considered less volatile) as a client approaches retirement age. A trend of rising interest rates are a concern for bond investors because bonds purchased in the past will have a lower yield and hence be less valuable than a currently issued bond.

This essay provides evidence for a rising interest rate until 2020. In this scenario, bonds purchased now will yield a lower interest rate than the bonds that will be purchased in subsequent years. This would cause bonds issued today to be less valuable than bonds issued in the future. It would cause an impact on the market that has not been felt in thirty years. This development should give investors a reason to be concerned about their exposure to the bond market. The knowledge that demographics have the potential to reverse the trend of falling interest rates is essential for all investors.

Note: The reference "Live Births and Birth Rates, by Year" was utilized throughout this article.

Disclaimer: This essay is not a recommendation to buy or sell any securities.

Source: The Correlation Between Demographics And Interest Rates