Then news of the COVID-19 Omicron variant broke, and markets quickly scaled back down their expectations of Fed tightening. To some, this feels like 2018, when Powell signalled a tougher monetary stance, the markets balked and the Fed blinked.
There’s a big difference, though. In 2018, inflation was running in a 2%-3% range; today it’s above 6% and likely to stay in a 5%-6% range for a while, as I argued above.
Several countries have re-imposed some COVID-related restrictions as a precaution, but we have no evidence at this point that the Omicron variant will plunge the global economy back in full-scale lockdown.
Markets seem to be betting that the Fed will want to take its own precautions and keep monetary support going as insurance against the downside risks to growth. After all, that’s what the Fed has promised and done over much of the past decade: with inflation risks always low, it focused on growth risks. This time, however, inflation is not just a risk, it’s a reality—a clear and present problem. And if the Fed holds off on tightening, it’s going to get worse. If the Fed does not tighten with inflation running at 5%-6%, inflation expectations will likely get even more unanchored.
Equally important, inflation has now become a serious political liability for the Biden administration. The longer consumers face rising prices, the more dissatisfied they become with the state of the economy. This translates into lower approval ratings for the administration and rising political pressure to bring inflation under control—and this pressure spills over onto the Fed.
Because of these important differences with 2018, I do not believe that the recent strong rally in bond markets can prove sustainable. Unless a new global recession really hits, because of Omicron or another unexpected shock, the bond market is likely underestimating the inflation problem, and underestimating the constraints the Fed now faces.
