At their December policy meetings, the US Federal Reserve and the ECB will be tested on their monetary policy stance amid higher omicron-related uncertainty. The possibility of a slightly more hawkish tilt in response to rising inflation has raised the stakes for credible forward guidance. Nonetheless, we still expect the overall tightening cycle to be less aggressive than suggested by current market pricing: shallow and protracted relative to historical standards in the US and little real tightening in the Eurozone. As pandemic-related one-off factors are fading, one of the key questions relates to what will happen to underlying inflationary pressures if the emergence of the potentially more damaging omicron Covid-19 variant slows the recovery momentum and delays the pace of re-opening. The Fed and the ECB have been careful about tightening their accommodative monetary stance too early, which has increasingly been challenged by markets. Effective policy rates are far too low at current inflation rates based on conventional monetary policy rules while market expectations indicate a tightening stance. Rising inflation expectations triggered by broadening price pressures could considerably erode the effectiveness of forward guidance and alter the scale and duration of monetary policy normalization (i.e., the “hiking cycle”).

A new Covid-19 wave could significantly prolong supply-demand imbalances and slow the recovery momentum. Tighter restrictions as well as partial (and more targeted) shutdowns will probably decrease aggregate demand but less so compared to previous waves (with real activity adjusting better to stricter containment measures). Core inflation in both the Eurozone and the US continues to be driven in large part by catch-up effects underpinning robust aggregate demand, not just supply-side constraints. Record levels of net disposable household income mean that there is still plenty of spare cash to disproportionately flow into the consumption of goods, especially if the pandemic disruption drags on for longer than expected. This might also delay the rotation of consumption back to services, where price pressures tend to be more short-lived. However, the replacement cycle for durable goods seems to be coming to an end, which would facilitate the adjustment of demand to tighter supply and soften price pressures.