Rearview Mirror: The top economics and market questions I got this week

How should we think about the omicron variant and the potential for endemic COVID?

No surprise, the question of the week was overwhelmingly about how the omicron variant might affect global growth. We’re (clearly) not epidemiologists, but as we think about the economy and markets, there are some basic tenets that have become clearer to us in the past 18 months in regard to COVID-19.

This is the framework I use:

1.??First, the virus can affect our economies in two key ways: through resulting changes in household/business behaviors (demand-side developments) and/or resulting government restrictions on economic activity, social mobility or trade (supply-side developments). Problematically, there aren’t really any robust ways to forecast these responses—different leaders in different jurisdictions have reacted differently, with varying results. We have tended to see that each wave of COVID saw a reduced behavioral response from households and businesses, but we also see that the relationship between the severity of a COVID-19 variant and official responses isn’t a constant and, crucially, isn’t especially forecastable. Like most government decisions, we can assume, but we can't necessarily 'model'. Keeping a very close eye on lockdowns and other restriction is thus the critical bridge between information about the new variant... and how it in turn impacts the global economy.

2.??Second, it’s become increasingly clear to us that we should stop thinking of COVID-19 as a one-off economic shock, as in, a natural disaster. Instead, we should shift toward a framework that views the virus from now on as a more minor (relatively speaking) but semi-permanent constraint on growth. That is, instead of everyone halting Activity X for 2 straight months, a 2-3% permanent reduction in participation in Activity X. If that's the case, we likely need to internalize a world characterized by, all things equal, a lower potential for growth, slightly higher inflation (probably around 2.5%), and a more persistent need for stimulus.

Is Fed Chair Powell and the Fed turning hawkish? What’s the play?

Fed Chair Jerome Powell testified before the Senate this week and the primary focus was on his comment that the word “transitory” could be retired with respect to inflation and that it would be appropriate to discuss accelerating the tapering of asset purchases at its December 14-15 meeting. Naturally, markets interpreted his comments as being hawkish and that the odds of a faster taper as higher.

And yet – here’s a bold statement – I’m not sure that whether the Fed increases its taper or not in December is really as important a call as emphasizing the bigger narrative shift that Chair Powell created this week. Over the past 18 months, we have lived in a world where “bad news is good news” as many bad data points and headlines suggested a more dovish central bank. But what we witnessed this week instead suggested that (a) the bar to a dovish policy put from the Fed is now much higher than it has been since March 2020 and (b) we may be entering a period where bad news is, effectively, bad news as it doesn’t create a dovish response from the Fed. Naturally, the market is appearing more nervous...

Should we worry about that big miss on the US labor market report?

In brief, I actually thought this was a good jobs market report. Yes, the US ‘only’ added 210k jobs in November, about half what was expected. But putting aside that many of the underlying details were just fine, the most important data point to me in this and the next several jobs reports for the U.S. is that labor supply is showing early signs of improvement. I’m obsessed with the labor force participation rate (LFPR). Without labor supply returning, we’ll continue to see wage pressures, weaker productivity than hoped for and ongoing restraints on growth as the job market remains rather dysfunctional. Effectively, we need U.S. labor supply so that the economy can transition out of the Stagflationary-type environment (uncomfortably high inflation with disappointing growth) that has been with us since Q2 of 2021 and back to a Goldilocks-type environment (slower inflation, improving growth) which we, in our base case, think returns in the second half of 2022.

And yet, the return of labor supply isn't a sure thing and has become increasingly difficult to forecast on a forward-looking basis. Yes, we know why labor supply has been weak in the last 18 months: fear of COVID-19, support from government assistance, pressures from virtual school for parents, slower immigration, and major early retirements. But few can explain is why LFPR hasn’t risen after many of these factors have dissipated. The improvement we saw in November is a good start, but there’s still a very long way to go from here. Indeed, in my view, that number will be far more important than whether the US adds 300k vs 500k jobs in the coming months.?