Could omicron be the trigger that bursts asset price and credit bubbles?

The United States is no stranger to asset and credit market bubbles or to the deflationary consequences of their bursting. After all, this is what occurred as recently as 2008. When the U.S. housing and credit market bubble burst, the Great Recession soon followed.

The 2008 experience makes it surprising that today’s economic debate is so heavily focused on the risk of returning to the inflation of the 1970s. This is especially the case at a time that the world is experiencing a much more pervasive asset price and credit market bubble than the earlier U.S. housing and credit market bubble. It is also surprising at a time that a new vaccine-resistant variant of the virus threatens a new round of economic dislocation that could prove to be the trigger that bursts today’s bubbles. 

Anyone doubting the pervasiveness of today’s global “everything” asset price and credit market bubble need only look at the financial stability reports issued by the Federal Reserve (the Fed), the European Central Bank (ECB) and the International Monetary Fund (IMF).

Those reports reveal that global equity valuations are at very stretched levels while housing price bubbles characterize all too many economies, including the United States. They also show that record amounts of money have been loaned at very low interest rates to highly risky borrowers in both the advanced and the emerging market economies. At the same time, exotic asset markets such as cryptocurrencies have gone through the stratosphere.

In regards to periods when financial market prices deviate from their underlying economic fundamentals, it is sometimes said that markets can stay irrational longer than you can stay solvent. While this is proving to be true of today’s asset price and credit market bubbles, there is reason to think that those bubbles might very well be reaching the end of their shelf lives. This is because those bubbles have been premised on the assumption that interest rates will stay at today’s ultra-low levels forever and that the world economic recovery will continue indefinitely at a satisfactory pace. Those two assumptions now are increasingly coming into question.

The main reason for concern that both the Federal Reserve and the European Central Bank might soon have to raise interest rates is that inflation is now running at its fastest pace in the past three decades and well exceeds both central banks’ inflation targets. Adding to this concern is the real risk that the new omicron variant of COVID-19 might delay the easing of supply chain bottlenecks and the rebalancing of demand between goods and services. Should that indeed occur, we will remain in a situation where demand for goods far exceeds their supply, which would keep inflation uncomfortably on the boil.

An even more serious concern for the continuation of today’s asset price and credit market bubbles is that the new omicron variant might induce renewed widespread economic lockdowns and might further disrupt already damaged global supply chains. Should that occur, the world economy could slow at a very much faster pace than the markets currently seem to be anticipating.

In the best of times, the bursting of asset price bubbles, either as a result of rising interest rates or disappointing economic growth, would pose difficult economic challenges. But their bursting today would be particularly challenging since they would be occurring across many asset classes and amid record high debt levels and dangerously high leverage ratios.

John Maynard Keynes purportedly advised economic policymakers to be prepared to change their minds when the facts change. His advice is particularly appropriate in today’s world of heightened economic uncertainty. If the latest COVID variant proves to be more transmissible and vaccine resistant than expected, it could prove to be the trigger that bursts today’s asset price and credit market bubbles. In that event, the Fed and the ECB should be quick to put on hold any plans to tighten monetary policy.

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.