Does Omicron change the monetary policy outlook?

Our unchanged outlook for central banks reflects that the starting point compared to Covid I is different in terms of the supply side and inflation, and Omicron could prove to be at least as much a supply shock as a demand shock (see our previous note here). However, we do argue that a very sharp tightening of financial conditions would be the game changer for central banks, though we are currently nowhere near close to that.

Fed still heading for faster taper and 2022 rate hikes

In his testimony to Congress yesterday, Fed Chair Powell confirmed the hawkish pivot of the Fed we recently flagged with our change in rate hike expectations. Powell followed up on comments from a range of FOMC members recently – doves and hawks alike – suggesting an imminent speeding up of tapering is on the cards. On this Powell said that the need for asset purchases has ‘clearly diminished’ and that it was appropriate to consider wrapping up purchases ‘a few months sooner’. The headline grabber was Powell’s remark that it was ‘probably a good time to retire that word’ in reference to the ‘transitory’ description of recent inflation developments. Indeed, the remarks were generally hawkish, with Powell now clearly prioritising bringing inflation under control over returning the labour market to pre-pandemic employment levels. On this, Powell said “To get back to the great labor market we had before the pandemic we’re going to need a long expansion. To get that, we’re going to need price stability,” adding that the Fed “must ensure higher inflation doesn’t become entrenched.” Powell’s comments were all the more notable considering they came after the news of the Omicron variant that has injected fresh uncertainty into the outlook. On Omicron, Powell acknowledged the downside risks this posed to the growth outlook, but he also said it meant ‘increased uncertainty for inflation’ – consistent with our view that Omicron could, if anything, put additional upward pressure on inflation. All told, the comments were consistent with our view that the Fed will announce a speeding up in tapering at its 14-15 December meeting, with purchases ending entirely by March rather than June. Thereafter, we expect the first 25bp rate hike to come in June, with an additional two hikes in September and December, and three more hikes in 2023.

ECB unlikely to extend the PEPP, but could maintain optionality

It might seem that the PEPP would be extended on the back of the eurozone’s struggle to contain the Delta strain and the new threat of the Omicron strain. After all, the function of the programme is clear from its name (Pandemic Emergency Purchase Programme). However, we do not expect a quick U-turn on the PEPP. First, there is limited information about the impact of the new strain. Second, even if Omicron leads to new global restrictions/lockdowns for a longer period, it is unclear at this stage what that would mean for the medium term outlook for inflation. The ECB reduced its medium term forecasts for inflation when the pandemic first broke, but over recent quarters it has been raising them and we are currently back in line with its pre-Covid outlook. Third, the ECB can maintain policy accommodation via its forward guidance on policy rates and by extending net purchases under the APP. There is a possibility that the ECB may delay a decision on the PEPP until early next year, but given the above considerations we think the central bank will push on and signal that the programme will likely end in March as planned. It could however maintain some optionality, by stressing that this scenario is dependent on developments, which it is monitoring carefully.

A sharp tightening of financial conditions could be a game changer

In big picture terms, central banks set policy to achieve a level of overall financial conditions that is appropriate given the inflation outlook. To put it simply, a higher medium term inflation outlook warrants relatively tighter financial conditions and vice versa. Even with a worrisome medium term inflation outlook in some economies like the US, if financial conditions were to tighten extremely sharply triggered by an aggressive risk-off wave, it could trigger a turnaround in central bank policy. So this is certainly something to keep an eye on as the effects of Omicron become clearer, and or, once markets start to price in a more aggressive trajectory for Fed monetary policy. Financial conditions have deteriorated in the US and the eurozone recently, but only modestly and very far from the tightening seen following Covid I – see chart above. (Nick Kounis, Bill Diviney & Aline Schuiling)