Insight - Omicron variant resurrects the risk of US stagflation

New Covid concerns: A file picture showing workers at a best buy store on Black Friday in San Carlos, California. The drivers of high and persistent inflation continue to broaden, making further increases likely in the months ahead. — Bloomberg

LAST week’s economic and Covid-related news may well resurrect a risk narrative that makes policy makers and virtually all financial markets particularly anxious: US stagflation, that awful combination of rising inflation and declining growth.

How this risk plays out in the next few months, however, is less than certain, though not because of the inflation component, whose continued upward movement is a near certainty.

The bigger question is the growth component, where the underlying private sector drivers, while still solid enough on a stand-alone basis to power through another Covid-19 disruption, could face potentially stronger headwinds because of the mounting risk of a policy mistake and tighter financial conditions in markets.

Coming on the heels of a consumer price index inflation sticker shock of more than 6%, last week’s PCE measure of core inflation, the Federal Reserve’s preferred gauge, came in at 4.1%, a multidecade high. Meanwhile, the growth outlook took several Covid-19 hits, starting with lockdowns in a handful of European countries.

This was followed by concerns about B1.1.529, a variant of the Covid virus that the World Health Organisation (WHO) has dubbed Omicron. On Friday, the WHO called Omicron a “variant of concern” because of the higher risk of infection and the possibility of vaccine evasion.

Several countries, including the United States, Canada and the UK, announced restrictions on travel from countries in southern Africa.

The markets’ reaction was immediate.

Risk assets sold off, including sharp losses in stocks worldwide.

The VIX, often thought of as a “fear index,” surged nine points to more than 27 last Friday.

Oil prices fell more than 10%.

Meanwhile, yields on US government bonds, including a 16 basis points decline in the 10-year Treasury, registered their biggest one-day move since last year.

The markets’ sharp moves were consistent with a reduction in overall economic dynamism and a partial rotation back to at-home activities because of Covid-19-related disruptions.

This was also deemed to lower inflation, according to the immediate move in market measures of inflationary expectations.

My own economic analysis suggests that extrapolating these market readings to the economic outlook should be done with some caution, and particularly so for inflation.

As last week’s data confirmed, the drivers of high and persistent inflation continue to broaden, making further increases likely in the months ahead.

Indeed, core PCE is already on track to reach 4.5% by the end of the year, if not higher.

This will continue to fuel wage increases, which – combined with continued supply disruptions amplified in the short term by the production and transportation effects of the new Covid variant –will fuel inflation well into next year. The growth outlook is more uncertain.

With still solid balance sheets, the household and corporate sectors are still strong enough to power growth through another Covid shock provided they do not face significant policy and market-related headwinds.

The top policy risk is a mistake by the Fed because of a continued misreading of inflation dynamics.

Such an error would also fuel market volatility and tighten financial conditions, adding to the contractionary winds.

While it is too early to deem stagflation a baseline scenario, its importance as a tail risk has grown because of the emergence of new Covid concerns.

Markets have already moved to price in a slower growth component, but they continue to lag in pricing in the inflation component. — Bloomberg

Mohamed A. El-Erian is a Bloomberg Opinion columnist. The views expressed here are the writer’s own.

Article type: metered
User Type: anonymous web
User Status:
Campaign ID: 46
Cxense type: free
User access status: 3
Join our Telegram channel to get our Evening Alerts and breaking news highlights

US , stagflation , Omicron , growth , insight ,


Next In Business News

Banks lead FBM KLCI lower amid weak market sentiment
New blueprint launched for financial sector
Lim Kok Thay steps down as chairman, CEO of Genting HK
Ringgit opens flat against US$ on wait-and-see mode
Foreign investors remain net buyers of RM11.35mil in Bursa equities
Equities extend retreat as US FOMC looms
Business news summary for Jan 17 to 23
Delivery partner of choice
Hong Kong’s financial sector faces talent crunch as expats head for the exit
Kohl's under fresh pressure as Sycamore expresses interest after Acacia made bid

Others Also Read