Omicron v Inflation​

By Jake Rickman​

What do you need to know this week?

Loretta Mester, president of the Cleveland Federal Reserve, expressed concern that the Omicron variant of the coronavirus could compound inflationary pressures around the world.

The concern is as follows: If Omicron proves to be more infectious by evading vaccines, there may be fewer workers in the labour force because of soaring infection rates. This, in turn, will increase the price of labour (as a general economic rule, things - including labour - cost more if demand outpaces supply).

The cost of certain goods like food and fuel would also rise, in part because businesses could pass the cost of the increased labour onto their customers. Businesses may also reduce the production of their goods or services, either because they will not have enough workers to sustain their output, or because they anticipate decreased demand for their goods and therefore cut production to save costs.

Even before Omicron, inflation levels have been at their highest point in decades. Dozens of countries, including the United Kingdom, have seen the cost of goods and services increase at rapid rates, which is the main effect of increased inflation.

Why is this important for your interviews?

If you can explain the way in which inflation may influence interest rates and the ways that the market might respond, you will demonstrate to interviewers an awareness of one of the most important “big-picture” economic concepts.

Historically, when inflation gets out of hand, central banks like the US Federal Reserve and the Bank of England, whose job is to control the supply of a country’s currency, will increase the interest rates to slow the economy down.

Increased interest rates effectively make it more expensive to borrow money because the interest rate banks charge businesses has increased. Therefore, businesses may be less inclined to borrow (or not borrow any at all). The big picture effect is that growth may slow because, on average, fewer businesses expand.

Before Omicron made its debut, central banking leaders were debating if the inflation was “transitory” (i.e., temporary) or “persistent” (i.e., here to stay). Team Transitory has been arguing that inflation was just an effect of the market readjusting to the increased demand for goods and services as we emerge out of lockdowns. Team Persistent pointed to more structural indicators.

The issue is that Omicron, if it proves to be highly infectious, could introduce substantial uncertainty into the market and make it more difficult for central banks to respond to inflationary pressures.

How is this topic relevant to law firms?

Interest rates influence how businesses borrow money from banks. If interest rates rise, it would be a radical shift from the past decade, which has seen historically low interest rates.

For a simple example, the growth in the number and size of M&A deals has in part been driven by low interest rates. This is because many acquisitions are financed by using a substantial amount of borrowed money (“leveraged finance”). If the Bank of England hikes interest rates to contain inflation, clients will need advice from law firms’ financing teams as to how this will impact any proposed acquisitions.