Santa is a hawk

We want to thank our readers for their attention and feedback throughout 2021 and wish you the best possible festive season and a great year 2022. The next Macrocast will come out on Monday 10 January.

Key points

• More sanitary restrictions emerging as Omicron spreads.
• The Federal Reserve (Fed)’s resolve to tighten quickly in 2022 looks strong. The European Central Bank (ECB) has pushed the debate on its rate lift-off to very late in 2022 or more likely to 2023.
• Three issues on our radar for January: escalation in Ukraine, the risk of severe supply-side disruption in China because of the “zero Covid” policy, possibilities of political upset in Italy around the presidential elections.

Unfortunately, we cannot close this year without taking a hard look at the pandemic again. Confirming our concerns from last week, although more indications emerged that Omicron triggers less severe infections, in many advanced countries the speed of propagation coupled with the presence of a significant minority of unvaccinated individuals create such a threat to healthcare capacity that more severe sanitary measures are being implemented. This could make for a mediocre Q1 2022 in terms of economic activity.

Also in line with our expectations, central banks across the Atlantic reacted differently to the new threat. The Fed has been even more hawkish than we thought, penciling in three rate hikes next year.  Yet, the market still believes this early tightening would “nip inflation in the bud” without having to go far into restrictive territory, and the Fed itself signals that throughout its forecasting horizon running until 2024 the actual policy rate could remain below the equilibrium level. Still, an “overkill risk”, where the economy would slow down so much that inflation would in the medium run return to its below-target pace from before the pandemic, is clearly priced in by markets. We find evidence of this not just in inflation-indexed bonds but also in the relative performance of cyclical equities. The ECB is not in such a hurry and with its new “soft open-ended” quantitative easing (QE) has pushed the debate on its rate lift-off to very late in 2022 and more likely to 2023. We notice that their GDP forecasts are consistent with a positive output gap in 2023 and 2024, while they expect inflation to be below 2% by then. That reflects a strong belief at the central bank that, at least in Europe, the bar to exit from the pre-pandemic low inflation regime is high, for all the hawks’ increasingly public concerns.

Ahead of the Christmas break, we sketch out the issues which will be on our radar in January: the possibility of an escalation in Ukraine, the risk that China’s zero Covid policy triggers a significant disruption in supply over there if Omicron takes hold, which would add to the global bottlenecks, and finally scenarios for a political upset in Italy around the presidential elections.