Michael Hicks
The Federal Reserve’s decision to cut interest rates by a half a percent in September marks a turning point in the most successful fight against inflation in U.S. history. This appears to be the quintessential soft landing for our economy—an end to inflation, without a recession.
So, how did we get here, and why was this time different?
Inflation is the general lower value of currency and is always caused by an excess supply of money. The excess supply of money comes from two sources. Governments can spend far more than they raise in taxes, injecting money directly into the economy. Or, interest rates can be kept very low, causing an increase in money supply through the banking system.
If households and businesses are rational and have good information about government spending, then they would treat excess government spending as a future tax increase. This tax increase can come in three forms. We could see an actual tax increase, we could see big future cuts in spending below tax revenues, or we could see inflation. In practice, we might see all three of these, as all three reduce government debt.
Monetary policy is a more common cause of inflation. It results from central banks, like our Federal Reserve, allowing too much money to be created through the banking system. Economists criticize central banking authorities for inflation because their control of the money supply tends to discipline government spending.
The COVID-19 pandemic was a perfect example of both fiscal and monetary policy contributing to inflation. Every nation in the world did two things to help sustain their economy through the pandemic. Every nation with a central bank cut interest rates, mostly to levels that were at or near zero. Every government tried to prop up domestic demand through payments to individuals and businesses.
In the U.S., we passed the CARES Act (under the Trump administration), the largest single stimulus package of any nation, at any time in the world. We later passed a much smaller American Rescue Plan (Biden administration). The Fed also cut interest rates to levels that were effectively zero, allowing banks to borrow without cost from the Federal Reserve system.
The first real hints of inflation began to hit in spring 2021 and peaked a year later. The timing of inflation means that the full weight of responsibility for rising price levels falls on the Federal Reserve, Congress and the Trump administration. It was they who cut rates and passed the unfunded CARES Act.
No Biden administration spending was in place before inflation started. That doesn’t free Biden from responsibility for the duration and magnitude of inflation. As I wrote at the time, the American Recovery Act was too large. It worsened and lengthened our period of inflation. But, the Biden administration could not possibly have caused inflation, because inflation was happening before any of its policies took effect.
Throughout 2021, both the Biden administration and the Federal Reserve were hampered in their judgment of the inflation threat by economic data that painted the economy as much weaker through 2021 than it was. The economic recovery happened in sectors that should not have led in economic growth, primarily services. So, it was not until administrative data became available in winter 2022 that the recovery turned out to be stronger than anyone know.
The Federal Reserve began aggressively raising interest rates through 2022 and 2023. Unsurprisingly, these cuts had about a six-month lagged effect on inflation, so we began to see inflation slow in September 2022.
Wages are also affected by inflation, but with about a one-year lag. So, for the first 12 months or so of inflation, the average real wages in the U.S. dropped. Fortunately, they’ve been rising since spring 2022, and are now above the pre-COVID level for all but the highest income workers.
None of this is really a miracle of monetary policy. A 36-month bout of inflation, which at annual rates, wasn’t in the top ten worst years out of the past half-century, is easy to remedy. The hard part was ending inflation without also causing a recession. And this time, the Fed really nailed it.
In the early days of inflation, the U.S. unemployment rate hit 50-year lows, and labor markets offered broad opportunities to workers of all skill and education levels. In many ways, 2021 and 2022 may be viewed as the best labor market conditions for less-educated workers in half a century. Americans were buying goods and particularly services, and that fueled record job opportunities and wage growth.
However, short-term inflation is almost always accompanied by strong labor markets. So, the Fed’s challenge was in ending inflation without cutting demand so quickly that jobs were lost. That is where good fortune and good analytics played a role.
The inflation of 2021 and 2022 led for such heavy demand for jobs that the U.S. economy had millions of unfilled positions. The goal of the Fed was to reduce inflation while only cutting the demand for jobs that weren’t filled. From the spring of 2022 through early 2024, it was able to just do that.
Job openings peaked at 12.1 million in March 2022, the month the Fed first raised rates, and fell to 7.6 million by July 2024. Over the same time, total employment rose by 7.4 million workers. Inflation shrank from its highest levels down to below 2.5 percent per year—the target maximum.
The entire developed world experienced COVID inflation. The American experience was just about middle of the pack. We have been fortunate in now getting back to normal levels of inflation without having experienced a downturn. In fact, last quarter, the economy grew at a robust 3 percent in inflation-adjusted terms. That is quite the opposite of a recession.
Over the coming decades, as we more seriously study the economic effects of COVID, it seems clear that the U.S. response to inflation will be viewed as not merely the most effective of the time, but as among the most effective of all time. We are immensely fortunate to have dodged a deep recession.
This luck doesn’t leave us without problems, just a much happier set of problems than we would’ve otherwise had to face. It was a miraculous soft landing.
Michael J. Hicks, PhD, is the director of the Center for Business and Economic Research and the George and Frances Ball distinguished professor of economics in the Miller College of Business at Ball State University. Hicks earned doctoral and master’s degrees in economics from the University of Tennessee and a bachelor’s degree in economics from Virginia Military Institute. He has authored two books and more than 60 scholarly works focusing on state and local public policy, including tax and expenditure policy and the impact of Wal-Mart on local economies.
