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Economist’s Take: Will Omicron Trigger a Setback or a Shutdown?

As the highly virulent Omicron variant of Covid-19 rages, it has affected society in myriad ways, including putting business supply chains at risk and consumer demand in flux.

Diane C. Swonk, chief economist at audit, tax and advisory firm Grant Thronton, in a new edition of her “Economic Currents” report, presents two scenarios for the first quarter and the effects of Omicron on the U.S. economy. Swonk noted that for the supply chain, China’s zero tolerance for outbreaks is already disrupting trade. The country’s push to idle factories to clean the air ahead of the Winter Olympics in Beijing “will exacerbate those problems,” she wrote.

Swonk’s Scenario 1 includes a temporary slowdown in consumer spending, while Scenario 2 shows a more dramatic pullback, as closures due to staffing shortages and contagion migrate from the service sector to the broader economy.

“Neither scenario includes additional stimulus, but stranger things have happened in election years,” she wrote. “The absence of fiscal support delineates Omicron from previous waves.”

Swonk said real U.S. gross domestic product (GDP) is expected to end 2021 on a high note, with growth of 6.7 percent in the fourth quarter, while growth for all of 2021 is estimated to average 5.7 percent, marking the fastest pace of growth since 1984.

Under Scenario 1, the Omicron surge is expected to be short-lived and abate quickly. Fear of contagion, coupled with a loss in hours worked, will slow but not derail consumer spending. Production is temporarily disrupted and supply chain problems will resurface, but demand will be weaker than it was through the Delta wave last summer.

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“Prospects for the first quarter are significantly weaker,” she wrote. “Our baseline is for 1.5 percent growth, which is a bit slower than we saw during the Delta wave in the fourth quarter. Omicron has collided with the Delta wave to cause disruptions to demand and supply. Consumer spending is the most vulnerable, but disruptions could extend well beyond the service sector. Businesses are expected to hesitate on executing investment plans until the dust settles.”

In this scenario, employment hits a speed bump in January as firms are forced to idle and schools move back online. Leisure and hospitality are hardest hit, while large online retailers are likely to retain seasonal workers to cover for those out ill. Inventories will be drained but not to the lows seen in 2021.

In this case, real GDP is expected to rebound at a 4.2 percent pace in the second quarter. Growth for 2022 is expected to average 3.7 percent, a half percentage point weaker than GrantThornton was expecting a month ago, but well above the tepid 2.3 percent annual rate in the decade leading up to the pandemic.

The core personal consumption expenditures (PCE) index, which takes out the volatile food and energy components, is expected to rise 4.6 percent from a year ago in the first quarter.

“That is cooler than we expected a month ago, but still the highest quarterly rate since 1989,” Swonk wrote. “A surge in inflation in the spring of 2021 set the stage for a moderation in year-over-year measures for the rest of the year. That does not mean the level of prices will fall, rather, the pace at which prices rise will slow. In response, the core PCE index is forecast to drop to a 2.5 percent pace in the fourth quarter.”

Under Scenario 2, the Omicron wave collides with the Delta wave on a global scale. Parts of Europe have followed the Centers for Disease Control (CDC) and shortened quarantine times for those infected because of the threat to economic activity. Outbreaks last longer and trigger losses in manufacturing and construction, as well as the service sector. Businesses and government offices are forced to close, mimicking a mandated lockdown.

In this case, real GDP contracts 2.2 percent in the first quarter, the first drop since the onset of the recovery. Employment drops in January and February and rebounds in March.

Real GDP bounces back at a 4.9 percent rate in the second quarter and growth for the year comes in at 3 percent. The core PCE index peaks sooner and cools faster in scenario 2. The contraction acts as a hard stop on the economy, derailing some of the upward pressure on inflation in goods and services.

Inventories built during the fourth quarter of 2021provide a buffer to shortages due to idled production. Core PCE inflation ends the year close to the Fed’s 2 percent target.

Swonk said the bottom line is that “forecasting during the pandemic has been akin to standing in quicksand–every time it seems we have a tether to pull us out, the ground beneath us shifts again in response to a new wave of infections.

“Hope is in the science that delivered us vaccines, treatments and ways to curb infections,” she added. “The thought that one of my next jabs might thwart all variants is especially encouraging. The prospect that the pandemic morphs into an endemic or something that is less of a threat and more manageable, is still high in 2022. One can dare to dream.”