Lingering Inflationary Impulses May Call for More Fed Action

• GDP data suggest the economy remains very strong
• However, there are signs that inflation may not go away easily
• This may call for more action by the Fed

The latest quarterly GDP data suggest the economy may be holding together quite well, along with a robust job market. The economy has also seen a boost recently as financial conditions have materially eased over the past few months.

Financial conditions, which are one way that Fed can transmit monetary policy, had become restrictive in the fall of 2022. Yet, the economy managed to grow at a very healthy rate in the third and fourth quarters, as the unemployment rate remained historically low.

Economic Tailwind

The recent easing of financial conditions suggests the environment is not restrictive. If financial conditions ease even further, it could aid in further economic stability and growth, but it could also lead to a resurgence in inflation.

Chicago Fed Financial Conditions Index

Effects of the easing of financial conditions have resulted in a resurgence in many commodity prices, like lumber, which has surged by more than 20% this month, and metals, like copper, have surged by more than 10% this month, as unleaded gasoline has also risen by almost 10% this month.

U.S. CPI Urban Consumer/Daily National Average Gasoline Prices

So, with financial conditions easing, the US economy holding together very well, and inflationary impulses showing a heartbeat again, one has to wonder if the Fed will have to do even more down the road to kill off the inflationary impulses that are not going away quickly.

Inflation Reaching Sticky Point

The Cleveland Fed is projecting CPI to rise by 0.6% in January and 6.4% yearly. That would be an acceleration month over month and practically flat on a year-over-year basis. In December, CPI fell by 0.1% month-over-month and declined to 6.5% year-over-year.

Chart, line chart Description automatically generated

The significant risk is if the Fed needs to raise rates above 5% in 2023 because the market has allowed financial conditions to ease so much that commodities like oil can move higher. Some signs suggest that may happen, too, with the price getting closer to breaking out of a consolidation phase and surging back toward $90, adding another inflationary impulse to an economy that is also struggling to break the inflationary cycle.

CFDs on WTI Crude Oil

This may work against the market in the long run because the market is so focused on looking at old data and trying to figure out when homeowners' equivalent rent is going to roll over that it is not paying attention to the surge in key commodity prices, which help to drive the direction of prices across the economy.

If the economy continues to hold together, the unemployment rate doesn't rise, and inflation stays elevated, it calls for the Fed to do even more.

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