Why the Era of Low Inflation Is Over

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The 30 years of stable inflation and falling interest rates that made central banks look heroic were mostly a demographic accident. 

The tailwinds behind that stability are reversing on roughly the same timeline. The choices central banks face in the next decade are ones they have not had to make in a generation, and the implications run well beyond the next FOMC meeting. In this article, we’ll explain exactly why.

The real reasons for stable inflation and falling interest rates

Three forces compounded between roughly 1990 and 2020. Baby boomers entered their peak working years. Women joined the workforce at much higher rates than in any prior generation, particularly in healthcare and education where their participation now exceeds that of men. China integrated into the global trading system, bringing not just low-cost manufacturing labor but skilled workers across nearly every level of the value chain.

Taken together, those forces added something close to 1.5 billion workers to the labor supply. Goods inflation fell sharply because Chinese manufacturing flooded the world with cheap inputs. Real interest rates fell, because investment opportunities in the West shrank relative to global savings. Governments could finance large deficits cheaply. Central banks looked like they had things under control because the forces doing the work were structural rather than monetary.

What is changing now?

Birth rates have fallen below replacement in most of the world, including India at the national level and across most Chinese provinces. Hungary, China, and several other countries have tried direct subsidies for childbearing without producing a meaningful response. The cost of raising children, the role of female labor force participation, and broader cultural shifts all point in the same direction. It’s difficult to foresee that pattern reversing anytime soon.

China's labor supply is now shrinking, and Chinese cities have started competing for migrant workers rather than absorbing them passively. Whether China has reached the Lewis turning point is debated, but the fact that the debate is playing out tells you about how mature the migration cycle has become. The post-pandemic surge in immigration into advanced economies generated a political backlash that has narrowed the space for immigration in the US, UK, and several other countries on a more or less permanent basis.

Government dissaving will outweigh higher household savings as societies age

The standard counterargument to demographics-driven higher rates is that people will save more if they expect to live longer, which should push real rates back down. That logic has merit at the household level, but it misses the role of government, and the omission turns out to be decisive.

As populations age, healthcare costs, pension obligations, and disability spending all rise sharply. Healthcare costs in particular grow faster than GDP, because medical technology compounds.

So, we end up with large structural increases in government dissaving. Almost any reasonable arithmetic puts the government dissaving above the increase in household savings, with the net effect being upward pressure on real rates rather than downward.

Housing demand persists even as population growth slows

A second under-appreciated channel runs through housing. The older a population becomes, the less housing fungibility there is between generations. Elderly homeowners are increasingly unwilling to move, and the homes they occupy do not pass smoothly to younger families. New family formation therefore requires new housing construction, which keeps real estate demand elevated even as overall population growth slows.

Rural depopulation in Italy, Japan, China, and parts of the United States compounds the effect. Population concentrates in cities where healthcare access and economic opportunity are stronger, which raises urban housing demand sharply. Make no mistake, the aggregate effect on real interest rates is upward, not downward.

Hyperscaler CapEx plus the fiscal bill add $1.3 trillion to capital demand in 2026

Hyperscaler CapEx will run roughly $700 billion this year, most of it funded from corporate cash rather than borrowing. The distinction matters.

Roughly $700 billion of cash that used to sit in money market funds, supplying cheap short-term liquidity, is being redirected into physical assets. That alone tightens the supply of loanable funds. The One Big Beautiful Bill adds an estimated $600 billion to the US deficit in the same year. Together that produces roughly $1.3 trillion of new demand for capital, with no corresponding increase in supply. The arithmetic mechanically pushes real rates higher.

There are non-financial channels as well. AI infrastructure requires very large amounts of electricity, and the social and political opposition to new data centers in places like Ireland and parts of the US suggests the supply response will be slower than markets currently price.

The two Phillips curves explain why past and future inflation have different drivers

The Phillips curve as typically taught conflates two different relationships. Goods inflation since the 1990s has been determined mainly by Chinese manufacturing and commodity prices, neither of which respond meaningfully to domestic interest rates. Services inflation responds to domestic labor markets in the textbook way.

The disinflation of the last 30 years was almost entirely goods-driven. Most central banks did very little real work, because cheap Chinese exports were doing the heavy lifting. The inflation of the next decade is more likely to be services-driven, because tighter labor markets and higher fiscal spending feed directly into services prices, and services are 70 to 80 percent of most advanced economies. Cutting rates can stimulate services demand. Raising rates can slow services demand, but only at a fiscal cost that is much higher than it used to be.

AI may reduce inequality by removing barriers to high-paid service jobs

The popular framing of AI assumes it will increase inequality by displacing workers and concentrating returns to capital.

A more careful reading might suggest the opposite is plausible. If AI removes the barriers to high-paid service jobs in fields like law and accounting, more workers can compete for those jobs. Aggregate income may compress in the middle and upper-middle rather than spread further apart. Of course, time will tell.

Lower inequality has a counterintuitive implication for interest rates. Recent work by Mian, Straub, and Sufi has argued that higher inequality pushes real rates down, because the rich save more and those savings flow into financial markets.

If AI compresses inequality even modestly, real rates rise rather than fall. That cuts against the standard market intuition that AI is universally deflationary.

The choice central banks have not had to make in a generation is coming back

Paul Volcker raised rates aggressively in the 1970s without destabilizing the fiscal situation, because federal debt-to-GDP was low. At today's debt levels above 100 percent in most advanced economies, the same response generates an interest expense problem that has to be inflated away later. Central banks face a choice between fighting inflation and supporting fiscal stability.

The market reactions to the Truss budget in the UK, French fiscal stress, and Japanese yen weakness suggest that bond vigilantes are starting to treat advanced economies the way they used to treat emerging markets. Brazil is the cleanest example of where this can go. Its nominal fiscal deficit is 8 to 9 percent of GDP. The primary deficit is under 0.5 percent. The rest is interest expense, and the central bank cannot cut rates without re-igniting inflation. Advanced economies at high debt ratios face a structurally similar trap.

One broad view of the central banking outlook is that the next decade will not look akin to the last 30 years, because the demographic forces doing the work have run their course. The next chapter requires central banks to make choices they have not had to make in a generation, and the decisions will shape the relationship between governments and central banks well beyond the next rate cut.

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DISCLAIMER: This article is based on a conversation from Top Traders Unplugged and reflects themes, ideas, and perspectives discussed during the episode. The views expressed are those of the guest and participants in the conversation and should not be interpreted as investment advice or as the official views of Top Traders Unplugged.

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