Omicronomics: the central bank response to the mutating virus
If investors were hoping for an early visit from Santa, they are likely to have been disappointed this week. The outbreak of Omicron is prompting public-health measures we have seen before, but unlike previous virus waves, it isn’t dissuading the inflation hawks.
When COVID-19 hit in the spring of 2020, policymakers around the world went into overdrive. The public health response was obviously front and centre in the battle against the disease, but monetary policymakers also chipped in, with sharp cuts in interest rates and large-scale asset purchases. The logic at the time was that a once-in-a-generation pandemic was triggering a collapse in demand that risked sending the global economy into a deflationary spiral. On one count, there were over 200 separate occasions in 2020 in which central banks around the world cut policy rates.
The public health response to Omicron is similar to previous waves: restrictions on social and economic activity to contain the spread of the virus and a vaccination push. But the monetary policy response is shaping up to be very different.
St Nicholas was an early Christian bishop from modern-day Turkey. So, it’s appropriate that of the 20 central banks meeting this week, the only one to cut rates was in Ankara. That sent the Turkish lira plummeting.
Tapering (and tapering by another name)
Less politicised central banks were moving in the opposite direction. We had rate hikes in Chile, Mexico, Hungary, Norway and the UK, and the Federal Reserve (Fed) and European Central Bank (ECB) accelerated their plans to stop buying assets.
In the UK, the Bank of England (BoE) surprised the market by voting 8-1 to increase interest rates to 0.25%. Economists thought the Monetary Policy Committee would again choose to 'wait and see' following the Omicron outbreak. Instead, they wanted to get on with the job and prevent inflation expectations drifting higher.
The ECB announced a lower run rate for asset purchases in Q1, whilst forecasting inflation at 3.2% in 2022. The language is important. The run rate of purchases is not “modestly lower” — it is definitively “lower.” We were also given a glide path towards an end to asset purchases over the balance of the year. They refuse to call it tapering, but that is purely an exercise in semantics.
In the US, the Fed delivered a policy mix that matched, and even slightly out-hawked, expectations. Asset purchases should be wrapped up by March, barring any further surprises, and they now expect three rate hikes in 2022, with another three to follow in 2023.
It’s worth reflecting on how far we've come. Go back twelve months, and there was a single lonely voice at the Fed calling for higher rates in 2022, and only a handful thought it would be appropriate in 2023. Now, every single member of the Federal Open Market Committee expects to raise rates next year.
Given the uncomfortably high starting point for inflation (4.1% in the Eurozone, 5.1% in the UK, and a staggering 6.8% in the US), the policy playbook in response to Omicron is very different to the original COVID-19 wave.
The experience of the last 18 months has shown the pandemic to be more inflationary than anyone anticipated. By restricting the supply of labour (due to self-isolation, home-schooling and early retirement) and the supply of goods (due to shortages in semiconductors, shipping containers and HGV drivers), the pandemic has put upward pressure on prices everywhere. Omicron makes that worse.
The BoE published a report from its regional agents alongside the policy decision. This week’s report mentioned "shortages" 36 times, and there were hints of a wage-price spiral developing: workers want more pay because prices have gone up, and companies are pushing up prices because of higher labour costs. In March 2020, policymakers feared a return to the Great Depression of the 1930s. In December 2021, they are suddenly more worried about a return to the Great Inflation of the 1970s.
The American economist Thomas Sowell once said, “there are no solutions; there are only trade-offs.” The appropriate policy response to the latest variant — let’s call it Omicronomics — has laid bare those trade-offs for global monetary policymakers, and that has uncomfortable implications for investors.
To be clear, these policymakers are in the process of lifting their foot off the accelerator, rather than stamping on the brakes. But that is enough to change the backdrop for financial markets. The days of endless liquidity indiscriminately driving up asset prices are coming to an end, and Omicron is doing nothing to slow that process.