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Has Omicron Changed Central Banks’ Response to Covid?

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Conventional wisdom so far is that as the pandemic puts pressure on the economy, central banks would keep up the stimulus. The immediate market response in the wake of the omicron variant discovery was to react in accordance with that notion.

The flight to safety came in conjunction with a move back towards higher-valuated tech stocks. This suggests that traders expected the easier monetary policy to continue.

But, there might be a flaw in that conventional wisdom, as highlighted by a recent article in the Financial Times. The article focused on how omicron was pushing the ECB away from stimulus.

In fact, this falls in the general theme that analysts are starting to point out. If the pandemic continues, particularly if current restrictions are maintained, then central banks might be more inclined to cut back stimulus.

The market isn’t intuitive

Central banks have been instrumental in supporting the economy over the last couple of years. Nonetheless, their job is to care primarily about price stability.

Stimulus during a recession can be a way of meeting that mandate. Typically during a recession, as we saw last year in the depths of the pandemic, there is deflation. Stimulus helps overcome deflation, in theory.

The script flips when inflation starts building.

If there is a slow recovery after the recession, such as following the 2008 crisis, then stimulus can be maintained for a long time. But if you have a relatively fast recovery, then a spike in inflation is expected. Hence, the argument from central bankers that inflation would be “transitory” during the bounce-back period.

Where things are going awry

Central bankers have become convinced that supply chain issues are causing inflation. At least, that’s what they insist on publicly.

The theory is that restrictions on travel due to covid are disrupting the ability to get goods across borders. Therefore, if there is a new covid variant of concern, the restrictions could increase or be prolonged. That would, in turn, extend the supply chain problems.

Using the central bankers’ logic, inflation could be longer than transitory. Therefore, the response to maintain currency stability would then be to bring easing to a close and potentially raise rates.

They should still do this, even if the economy is underperforming due to the pandemic. As long as the economy isn’t slipping directly into a recession, then winding down stimulus is justified within the mandate of most central banks.

The hawkish tilt

As some central banks raise rates, this puts pressure on others as well.

In particular, the ECB is under pressure, even if it has the least reason to end their stimulus. The Fed’s hawkish tone supports dollar-denominated bond yields. This means that investors are likely to move their capital across the Atlantic. And that would weaken the euro and make the inflation problem even bigger for the ECB.

That is why the risk of prolonging the pandemic measures could actually translate into a potential for less stimulus. Analysts are already pointing this out. And eventually, that kind of thinking will affect the markets.

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