The inflation surge is over. Now we'll see if interest rate increases cause recession.

Over the last two years, inflation – the rate at which the prices of the goods and services consumers purchase rise – has dominated the headlines.

As recently as June 2022, inflation ran at 9% on a yearly basis. Since then, it has come down dramatically, to 3.7%. So the cost of running a household continues to rise, but at a much slower pace than before.

In the post-World War II era, inflation averaged 3.5% a year. The period 1973-82, marked by oil shocks, brought an increase to 8.8%. In the three decades before the COVID pandemic, however, inflation remained relatively low, averaging only 2.5%. It dropped to 1.9% between the end of the Great Recession in 2009 and the beginning of the pandemic. The recent peak was high in comparison to very recent history, but still below the levels recorded in the 1970’s and early 1980’s.

Who is to blame for inflation? Biden and Trump played part.

It’s generally acknowledged that a number of factors contributed to the initial rise of inflation in 2021. As the pandemic eased up, people began buying more goods and fewer services, driving price increases. To make matters worse, the economy suffered from supply chain problems and labor shortages that drove up up the price level.

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The inability to supply and transport the goods now in higher demand was true both in the US and abroad (most importantly, perhaps, in China). This is why the price of services did not increase along with the price of goods at first.

Fiscal policy comes into play to the extent that the various pieces of legislation – the CARES Act (under Trump) and the American Recovery Package (under Biden) provided households with extra spending power.

In early 2021, some economists argued that inflation would soon come down while others argued that the mix of expansionary fiscal and monetary policy meant indefinitely higher inflation. In the end, higher rates persisted longer because supply disruptions persisted longer than anticipated (remember semi-conductor chips), and perhaps more importantly, the Russian invasion of Ukraine and accompanying geopolitical frictions led to higher oil prices.

Another unanticipated source of inflationary pressures was the tight housing market and accompanying high rent and housing costs. These costs have a high weight in the CPI, so that the housing crisis added to upward price pressures.

As much as some may try, we can’t blame any single institution or political party – there are just too many factors contributing to inflation. The $4 trillion federal government spending during the Trump administration propped up prices by allowing individuals and businesses to keep buying goods and services. Meanwhile, the Federal Reserve’s commitment to low interest rates and emergency lending kept the economy afloat at a time when steep price declines could have been disastrous.

The $1.9 trillion American Rescue Plan passed during the Biden administration added to upward pressure on prices. The fiscal policies contributed to much of the acceleration in inflation in 2020 through mid-2021. However, starting in mid-2021, supply chain disruptions and labor market tightness, more related to the pandemic, took on more importance. The oil price increase in the wake of the Russian invasion of Ukraine was particularly important in mid-2022.

Overtightening interest rates runs the risk of recession

Inflation is typically portrayed as a bad thing that we must avoid at all costs. However, in this case, at least some portion of this inflationary surge is a necessary side effect of economic aid that has helped keep Americans out of poverty and businesses solvent during an unprecedented global pandemic. Yes, inflation would have been lower without multiple economic recovery packages and the Federal Reserve’s reduction in interest rates and purchasing US government debt. But not taking these actions would have come at the cost of numerous bankruptcies, higher unemployment and tremendous economic hardship for families.

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Looking forward, the inflation surge is probably over. The upward pressure in rental rates is dissipating, while supply chain problems have already disappeared. Finally, because the Fed has been raising interest rates over the last year and a half, thereby slowing the economy’s growth, the labor market has cooled substantially, further relaxing upward price pressures.

That means that in the absence of any big surprises – like another large disruption to oil markets – inflation is likely to continue to moderate, although perhaps more slowly than most people would like. On the other hand, if the Fed has already overly tightened – as the effects of past interest rate increases continue to ripple through the economy – inflation may fall even faster, although perhaps at the cost of a recession.

Menzie Chinn is a Professor of Public Affairs and Economics in the UW-Madison’s La Follette School of Public Affairs and Department of Economics. His research examines the empirical and policy aspects of macroeconomic interactions between countries. He publishes regular updates on current economic conditions and policy in Econbrowser.