The Risk for Markets Isn’t Higher Interest Rates

Equity market optimism could simply mean that investors see these policies as broadly adequate for each economy’s needs. After all, a growing economy can cope with a few rate increases and, if the Omicron variant of Covid-19 proves destructive, officials could easily change course.

“Under the present circumstances, it is very unlikely that we will raise interest rates in the year 2022,” ECB President Christine Lagarde said, emphasizing that the eurozone’s elevated inflation—4.9% in November—is a result of energy shortages. This puts the ECB on a divergent path from the other two central banks, which are expected by the market to tighten policy aggressively next year. “These economies are at two different stages in the cycle,” given the greater amount of fiscal stimulus deployed in the U.S. and poor wage growth in the eurozone, Ms. Lagarde added.

What investors may not be taking into account, though, is that the mere resurgence of inflation, whether transitory or not, is making central bankers far less sympathetic toward full employment than before.

The BOE is an example of this. Last month, BOE Gov. Andrew Bailey conditioned rate rises on a coming labor-market report that would allegedly clear up whether the end of the U.K.’s furlough program in September had led to higher unemployment. When the numbers came, they showed little deterioration, opening the door to Thursday’s move.

However, as Tomas Hirst, European credit strategist at CreditSights points out, it is hard to give full credence to numbers suggesting that the million people who were furloughed just two months ago instantly found full-time jobs. Meanwhile, surveys of purchasing managers suggest that the British economy is already suffering the impact of Omicron. As a result, traders were expecting more caution from the BOE, and were once again caught off guard by its actions.

Similarly, there is a danger that the U.S.’s hot labor market leads policy makers to forget that the share of people of working age in employment remains below pre-Covid levels, as is also the case in the U.K. and the eurozone. Some economists are pushing the idea that these economies are already at full employment, because the pandemic has brought about deep-rooted changes that will make some people not want to return to the workforce. But this is eerily similar to views espoused after the 2008 crisis, which ultimately led to a weak and slow labor market recovery. This is what central banks had pledged to correct with their updated policy frameworks.

It is more likely that job seekers simply need time to be matched with employers, and that pre-pandemic employment ratios can be reached or surpassed. Yet central banks have started their tightening cycle before this has come to pass, even as new Covid-19 strains increase uncertainty.

The rate increases priced in today aren’t particularly concerning. But just as low inflation kept raising the bar of what is considered full employment, high inflation may keep lowering it.

Write to Jon Sindreu at jon.sindreu@wsj.com