Aging U.S. population weakens Federal Reserve interest rate tools

The Federal Reserve faces a growing structural obstacle in its effort to manage inflation and employment. As the U.S. population ages, the economy is shifting away from manufacturing and toward the service sector. This change alters how the economy responds to interest rate adjustments, potentially reducing the effectiveness of the central bank’s primary monetary policy tool.

The service sector’s share of gross domestic product has expanded substantially over the past two decades. In 2000, services accounted for 73.9 percent of GDP. By 2024, that figure had risen to 79.7 percent. This nearly six-percentage-point increase reflects broader trends in income growth and productivity. Higher incomes lead households to spend more on services relative to durable goods. Additionally, productivity gains in manufacturing have outpaced those in services, raising the relative price of manufactured items.

Demographics play a direct role in this shift. Households with members over 65 consume a different mix of goods and services than younger households. Older Americans tend to spend a larger portion of their income on healthcare, financial services, dining, and travel. Younger households, by contrast, allocate more resources toward vehicles, housing, and other durable goods. Economists at Cravino, Levchenko, and Rojas estimate that 20 percent of the increase in service-sector spending in the United States is driven by this aging demographic.

Research by economist Jaeho Lee provides further insight into the scale of this demographic impact. Lee found that in industrialized countries, a one-percentage-point increase in the share of the population aged 65 or older raises the service sector’s share of total output by slightly more than one percentage point. Over the same period, the manufacturing share of output declines by one percentage point. This structural reallocation changes the sensitivity of the economy to monetary policy.

Interest rates primarily influence the economy through the cost of capital. Higher rates increase the expense of investing in machinery, computers, and other capital goods. Manufacturing is a capital-intensive industry, making it more responsive to these cost changes. Consumers also finance large purchases like vehicles and appliances with credit, so higher rates dampen demand for manufactured goods. The service sector, however, relies less on capital investment and consumer credit, making it less sensitive to interest rate fluctuations.

Lee’s analysis indicates that a one-percentage-point change in interest rates has three times the effect on manufacturing output compared to the service sector. As the service sector grows in relative size due to aging and other factors, the overall economy becomes less responsive to rate changes. Consequently, the Federal Reserve may need to implement larger interest rate increases to achieve the same level of demand reduction and inflation control.

Robert Krol, an emeritus professor of economics at California State University, Northridge, notes that these demographic shifts add complexity to the Fed’s mandate. The central bank must now account for a larger service sector when calibrating policy. This structural change suggests that traditional monetary policy tools may require stronger adjustments to maintain price stability in an aging economy.