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Omicron: How Much Damage Can It Do to the US Economy?

Image: Creative Commons.

John Maynard Keynes famously said that “when the facts change, I change my mind. What do you do sir?”. Today with widespread reports of a new strain–going by the name Omicron–of the Covid-19 virus, it would seem that the facts have changed with respect to the US and world economic outlook. That change merits our rethinking as to where the US and world economy might be headed.

While to be sure, it is yet too early to know exactly how transmissible and how vaccine-resistant the Omicron variant might be, it is not too early to know that the news of that variant is causing governments around the world to reimpose travel restrictions and to reinforce Covid preventive measures. That would make it prudent for economic policymakers to reassess their present economic and financial market outlooks for next year.

In assessing the likely impact of the new variant’s spread, it is important to bear in mind the challenging economic and financial market circumstances in which the new variant will be occurring. Not only is US inflation now running at its highest level in the past thirty years as indicated by consumer prices now increasing at a 6 ¼ percent clip. US asset price and credit markets seem to be in bubble territory.

One indication of troubling asset price bubbles is the fact that US equity valuations are now at very lofty levels that have been experienced only once before in the last one hundred years. Another is that US housing prices in inflation-adjusted terms are higher today than they were in 2006 on the eve of the bursting of the US housing and credit market bubble.

Against this background, it would seem that in a best-case scenario, Omicron’s economic damage might be limited to prolonging the return to the more normal functioning of the global supply chain and to preventing the early return to the rebalancing of demand away from goods and towards services. Those considerations could keep inflation at an uncomfortably high level for longer than the Federal Reserve is currently expecting. It might also force the Fed to raise interest rates very much earlier than the Fed is currently planning to keep inflation under control.

Omicron: The Worst-Case Economic Scenario 

In a worst-case scenario, it might turn out that Omicron is very much more transmissible and vaccine-resistant than was the delta variant. If that indeed turned out to be the case, we should brace ourselves for a substantial hit to household and investor confidence both at home and abroad. While that might cool today’s inflationary pressures and forestall Fed interest rate hikes, it would constitute a major headwind to the US and global economic recoveries.

All of this does not bode well for financial markets next year. This would seem to be especially the case considering that their stretched valuations are premised on the assumption that ultra-low interest rates will go on forever and that the economic recovery will continue indefinitely. In the best Omicron case scenario, it would be higher than expected Fed interest rates that might burst the US equity and housing market bubbles. In the worst-case Omicron scenario, it would be disappointing economic growth that might be the trigger for the bursting of those bubbles.

Needless to add, the last thing that President Biden needs in the run up to the mid-term elections is higher inflation or disappointing economic growth. That would seem to particularly the case since either of those two economic eventualities could soon burst today’s asset and credit market bubbles.

Desmond Lachman is a senior fellow at the American Enterprise Institute. He was formerly a deputy director in the International Monetary Fund’s Policy Development and Review Department and the chief emerging market economic strategist at Salomon Smith Barney.

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Desmond Lachman joined AEI after serving as a managing director and chief emerging market economic strategist at Salomon Smith Barney. He previously served as deputy director in the International Monetary Fund’s (IMF) Policy Development and Review Department and was active in staff formulation of IMF policies. Mr. Lachman has written extensively on the global economic crisis, the U.S. housing market bust, the U.S. dollar, and the strains in the euro area. At AEI, Mr. Lachman is focused on the global macroeconomy, global currency issues, and multilateral lending agencies.