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Renewed restrictions: inflationary or disinflationary?

  • If Omicron turns out to be malign enough to prompt tighter restrictions, we suspect that the net result would initially be for inflation to be lower than otherwise. But by worsening product and potentially labour shortages, restrictions on household activity could end up keeping inflation above targets for longer.
  • As we have already stressed in our various notes on Omicron, it is too early to say if the new variant will prove dangerous enough to force governments to enact tighter restrictions on movement and economic activity. At this stage, though, we can still think through whether the demand or supply effects of renewed restrictions would dominate, and hence if the balance of risks leans towards higher or lower inflation. To be clear, due to a mixture of base effects, fading re-opening inflation, and (likely) falls in commodity prices, headline inflation is almost certain to fall next year in most economies. Therefore, the question here is not whether inflation will fall in 2022, but rather how Omicron might alter the pace or extent of the fall.
  • Amid all the uncertainty, one point in which we can be reasonably confident is that if Omicron is going to have an effect on inflation via energy prices, it will be disinflationary. Indeed, the price of Brent crude has already fallen from $82pb a week ago to just over $70pb at the time of writing in anticipation of weaker oil consumption in the months ahead. If tighter restrictions were imposed, prices could fall further.
  • That said, the Omicron-induced drag on inflation from lower energy prices can be overstated. For one thing, restrictions on travel and hospitality would make little difference to the outlook for natural gas demand and prices, and hence for household energy inflation, particularly in Europe. And as for oil, investors have been expecting OPEC+ to increase output by 5m bpd by end-2022. But if tighter restrictions dented demand, we suspect that OPEC+ would put a floor under prices by restricting supply. With a $60pb floor, DM inflation might be just half a %-pt lower than our forecast in H1 2022. (See Chart 1.) Of course, the outlook for oil prices is especially uncertain right now. But the key point at risk of being overlooked is that an OPEC+ supply response may mean that oil prices might not fall far enough to make a huge difference to inflation in 2022.
  • Meanwhile, by causing shortages to worsen, renewed restrictions could add to core inflation. Admittedly, looking through tax effects, core consumer prices in major advanced economies simply grew at their pre-virus trend rates during the virus wave and restrictions between last November and March. Back then, while resilient demand prevented price falls, supply constraints and resultant shortages were only just emerging and were not bad enough to exert significant upward pressure on prices. (See Chart 2.) But product and labour shortages worsened thereafter and were accompanied by above-trend rate increases in core prices.
  • Thinking first about supply, it’s already failing to keep up with demand, even ahead of tighter restrictions. And a significant Omicron wave would presumably be met once again with at least intermittent factory and port closures in Asia. China seems unlikely to back away from its zero-COVID strategy, especially if Omicron proves harder to contain than Delta. At the same time, worries about the new variant’s health implications might dissuade workers from returning to the labour market or perhaps even cause some to drop out. Taken together, a tightening of restrictions would probably cause supply disruptions to intensify.
  • The bigger uncertainty lies on the demand side. On the one hand, there is arguably much less scope for monetary and fiscal policy to respond this time, particularly in the US. What’s more, firms and consumers may have exhausted their appetite for office equipment and furnishings, so there may not be as much demand for spending on traded goods. On the other, private sector finances are in good enough shape to facilitate another shift in spending away from services towards maintaining high levels of goods spending.
  • Ultimately, compared to previous virus waves, the starting point in terms of shortages is so much worse this time around. And if we are right that OPEC+ may be able to prevent oil prices from tumbling, then energy disinflation might only offset stronger core – particularly goods – inflation for a short period of time. Therefore, after a net drag on inflation in the first half of 2022, our sense is that the balance of inflation risks is tilted to the upside. It’s still early days, but recent comments by policymakers suggest that they are downplaying the risks of Omicron to the economy and remain more concerned by the inflation outlook.
  • We will shore up our thinking about the inflation outlook in our Global Inflation Watch in a couple of weeks’ time, by which point we’ll hopefully have a better idea of the risks posed by the Omicron variant.

Chart 1: Oil Price & Fuel Contrib. to DM Inflation (%-pts)

Chart 2: CE G7 Shortages Indicators (Standard Deviations)

Sources: Refinitiv, CE G7 Shortages Indicators Dataset, Capital Economics


Simon MacAdam, Senior Global Economist, +44 (0)20 4808 4983, simon.macadam@capitaleconomics.com

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