In December 2024, in Springfield, Missouri, the Show-Me Institute and Show-Me Opportunity hosted an event featuring Dr. Aaron Hedlund, Chief Economist at the Show-Me Institute, and Elijah Haahr, former Missouri Speaker of the House and host of The Elijah Haahr Show on KWTO.

The discussion focused on the 2025 economic outlook for Missouri and the U.S., exploring issues such as unsustainable government spending, the growing national debt, and the Federal Reserve’s role in shaping inflation, housing, and labor markets.

This episode is a recording of that event.

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If Missouri’s elected officials are serious about addressing our state government’s unsustainable growth, they should look at past efforts undertaken across the country to see what might work. Perhaps the most successful state-based cost-cutting initiative in history was then–California Governor Ronald Reagan’s 1967 executive order creating the “Governor’s Survey on Efficiency and Cost Control”. (The text of that order is available here.)

Reagan’s blueprint outlined some some key principles that any Missouri initiative should consider:

Governor Created

• The Governor is the elected official best situated to coordinate an effort that examines all parts of Missouri government and to start implementing solutions. He can ensure that all executive branch officials cooperate in providing information and executing reforms.

Goal-Oriented

• To help ensure success, the initiative needs to start with a clear mission, a top-level objective, stretch goals, and a commitment from everyone involved (inside and outside government) to reach those goals.
• Much of the data needed to inform decisions will not be immediately available. Rooting out inefficiency will require targeted requests or establishing new metrics to get the information necessary to achieve the initiative’s goals.

Led by Non-Government Experts

• Reagan understood that getting a handle on government growth required innovation, creativity, and outside-the-box thinking that could only come from those outside of government. A Missouri initiative should seek insights from business executives, nonprofit experts, former government officials, and financial consultants with prior public-sector knowledge or experience successfully turning around companies.

Privately Funded

• Efforts to find cost savings in government shouldn’t be dependent on government funding for functioning. Reagan’s efficiency initiatives at both the state and federal level were entirely funded by private sources.

Pre-Specified Timelines

• Time is of the essence for Missouri when it comes to cutting costs. Ensuring the work is completed in a thorough and expedient fashion will require deadlines, perhaps with the option to extend them based upon meeting preapproved metrics.

Commitment to Implementing Solutions

• One of the biggest hindrances to Reagan’s cost-cutting efforts was a lack of legislative commitment to implementing the survey’s recommendations. In fact, only about one third of the recommended cost savings could be realized without any legislation being passed. Going into the efficiency exercise with a commitment from legislative leaders will be key for the initiative’s lasting success.

All told, Reagan’s citizen-led commission of more than 200 private-sector leaders was able to recommend, in short order, more than 2,000 reforms to improve California’s government operations and significantly cut costs. These recommendations included long-term savings estimates for California taxpayers of more than $500 million, which if adjusted for inflation would amount to about $4.2 billion today.

A similar result for Missouri today would be a much needed step in the right direction. It’s long past time for a serious effort in Jefferson City to rein in the state government’s excess, and taking a page out of Reagan’s book by turning to the private sector for meaningful solutions might be the most promising path forward for achieving long-term success.

Following the Reagan and DOGE frameworks, here are some specific examples of what a Missouri initiative could look like:

Creation

• Establish by executive order a Missouri Office of Government Efficiency (MOGE)

Objective

• Mission: The Missouri Office of Government Efficiency (MOGE) would conduct a comprehensive review of Missouri’s government. This review would include all services, programs, spending, regulations, and administrative practices. The goal would be to determine how Missouri’s government can be improved, as Governor Reagan specified in his original executive order, to be “the most efficient, expeditious, and economical” in the country.
• Pre-Specified Timelines: This review, along with actionable recommendations, should be completed by no later than December 31, 2025.
• Insights from Business (performance metrics): Given that Missouri’s budget is approximately twice its pre-COVID size, federal COVID relief for states is ending, and state tax revenues are down, a reasonable goal would be to return Missouri to its fiscal year 2019 cost trajectory unless a cost–benefit analysis by MOGE clearly justifies an alternative savings target. In dollar terms, this would amount to an approximate inflation-adjusted reduction of $2 billion in general funds.

Organizational Structure

• Led by Nongovernment Experts: The governor could appoint two highly respected leaders from outside of government who have a proven track record of delivering transformational change to large organizations to lead MOGE. In addition, to help ensure the initiative’s success, MOGE leadership should be allowed to select any additional staff or members they deem necessary to conduct the review.
• Privately Funded: The Governor or his allies could fundraise, as Reagan did, to fund MOGE. Ensuring that all funds used to conduct the work of MOGE come from private rather than public sources removes any undue leverage that government could have over MOGE and its policy recommendations.

Commitment to Implementation

• Agency Cooperation: The Governor could order all government agencies to give full and timely cooperation to any MOGE requests for access to data or other information that MOGE deems necessary to conduct its work, except for any instances expressly prohibited by law.
• Citizen Participation: MOGE leadership should commit to publishing intermediate findings and recommendations, formally submitting progress reports to Missouri’s General Assembly, and creating a website or holding public hearings to solicit input from members of the public who in many cases have pertinent first-hand knowledge of government inefficiencies and needed services that MOGE’s internal audit of agencies may not fully uncover.
• Legislation: Fostering input and cooperation from Missouri’s General Assembly will be essential to achieving MOGE’s specified goals. To that end, the Governor should seek a commitment from legislative leaders both to cooperate with the MOGE efforts and to advance the legislative initiatives recommended to reduce the cost and increase the productivity of state government.
• Transparency: MOGE leadership should make all final recommendations public with supporting analysis and make its leadership available for public hearings and information sessions to explain its findings and methodology.
• Accountability: After MOGE issues its recommendations, the executive branch should be required to respond to every agency recommendation by either implementing it in full or detailing why it is not doing so.

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On August 12, the Show-Me Institute and Show-Me Opportunity hosted a virtual event where Elias Tsapelas, director of state budget and fiscal policy at the Show-Me Institute, and Aaron Hedlund, chief economist at the Show-Me Institute, made the case for a Missouri Taxpayer Bill of Rights. The event explored the limitations of the current Hancock Amendment, proposed reforms to better protect taxpayers in the state, and more.

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On May 15, 2024, Show-Me Institute Chief Economist Aaron Hedlund joined Pete Mundo on KCMO to break down the latest inflation data and discuss what it means for the Federal Reserve’s next move on interest rates.

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This same ambiguous outlook applies to the U.S. economy as a whole. On the one hand, data released by the Department of Commerce last week reveals that real gross domestic product (GDP)—the value of all goods and services produced by the US economy, adjusted for inflation—increased at a 2.4% pace in the second quarter, following 2% growth in the first quarter. If this pace continues—a big if—then the economy will have safely avoided recession territory, having rebounded modestly from the two quarters of negative GDP growth at the beginning of 2022.

But past is not prologue. The economy still faces multiple headwinds that leave the risk of recession—or at least a significant weakening of growth—very much on the table. For one thing, the effects of monetary policy (i.e., rate hikes) on the economy operate with a time lag. The primary mechanism through which rate hikes fight inflation is by making borrowing costlier, thereby discouraging the demand for spending and, with it, the pressure on prices. The medicine from earlier doses of rate hikes is already having an effect on the economy; headline CPI inflation fell to 3% year-over-year last month, down from a peak of over 9%. However, rate hikes from late spring have not yet fully reverberated throughout the U.S. economy. Even so, the recent GDP data indicate that consumer spending only grew by 1.6% in the second quarter, with durable goods spending only growing by 0.4%. This particular subset of spending is useful as a gauge because durable goods like washing machines and other expensive household items are often purchased using credit, which now commands higher interest rates because of the Fed’s actions.

Another headwind facing the economy is the impending resumption of student loan repayments this fall. Make no mistake: student loan repayments ought to resume. Bailing out student debt by transferring it from the people who are reaping the financial gains from their education to taxpayers is regressive, fiscally irresponsible, and inflationary. However, this reality does not take away from the fact that people will feel the sting of being required to pay debts that they have been shielded from during the past few years. Consequently, consumer spending growth is likely to slow further or even turn negative. Considering that consumer spending contributed 1%age point (out of the 2.4) to GDP growth in the second quarter, a hypothetical scenario where consumer spending growth flatlines would by itself reduce GDP growth to just 1.4%. Moreover, another important component of GDP—investment—is sensitive both to rates themselves as well as business expectations about future consumer demand. It is entirely plausible—maybe even likely—that investment growth will decline from its most recent rate of 5.7%, and if that happens, GDP growth could easily fall below 1%.

Still another important headwind is the fact that, for all the progress the Fed—and the Fed alone—has made in combatting inflation, it has not yet succeeded in achieving its 2% target. As shown in the figure below, headline inflation is down to 3%, but core inflation—a better measure of fundamental pricing pressures—is still nearly 5%. Moreover, because the inflation readings are year-over-year measures, and because the monthly numbers from July and August 2022 were very low, it is quite possible that the headline year-over-year inflation numbers may rise modestly over the next few months.

Lastly, and arguably most importantly, the U.S. economy has been facing a productivity crisis over the past two years. Productivity—that is, economic output per hour of labor—has decreased by nearly 2.5% since the second quarter of 2021, which is unprecedented. By comparison, productivity rose by nearly 5% from the first quarter of 2017 to the fourth quarter of 2019. Not coincidentally, that earlier period corresponded with household income rising by over $5,000 after inflation—meaning higher purchasing power—as compared with the recent decline in purchasing power of over $2,000. The figure below gives a stark visual reminder that prices have grown consistently faster than wages since the passage of the American Rescue Plan Act “stimulus” bill in early 2021, with price growth decreasing only in response to the Federal Reserve’s interest-rate-hiking campaign.

As speculation continues over the near-term trajectory of the U.S. economy, it is worth mentioning again the essential need to raise productivity—not just to avoid recession, but to lift the economy out of the doldrums of 1% to 2% growth and return to or exceed its historical norm of 3% growth. While these numbers may seem difficult to relate to, a rule-of-thumb may prove useful. The amount of time (in years) that it takes for the U.S. economy to double in size is roughly 70 divided by the growth rate. Thus, if an economy grows at 3% per year, it will take approximately 70/3 = 23.3 years to double in size. By contrast, if the economy grows at 2% per year, it will take 70/2 = 35 years to double, and it will take 70/1 = 70 years to double if growth is persistently only 1%. That would be a disaster for the U.S.’s potential to remain the leading economy in the world.

So how do we achieve growth liftoff? Answering this question is much too large for a single blog post, but the key is productivity, and one important point to remember is that raising productivity is not about squeezing more out of workers and making life at work more of an unpleasant grind. Quite to the contrary. The most effective way to increase productivity is to ensure that workers are equipped with the skills to succeed, unencumbered by regulations to find the best occupation and employer to realize their potential, and where both workers and employers are able to keep more of the fruits of their productive activity. That phrase—productive activity—is key to keep in mind. While public debate often focuses on spending, spending, spending, it’s time to shift our attention to producing.

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The good news: progress has been made. According to data released last week, the May consumer price index (CPI) inflation rate came in at 4%, which is far less than the 9% peak from mid-2022. However, now is not the time to move the goalposts. For years, the Federal Reserve has said its inflation target is 2%, and the economy is running at twice that rate. By contrast, before passage of the American Rescue Plan Act stimulus bill in early 2021, the economy had consistently remained at or below 2% inflation for the better part of a decade and had not hit 9% in over four decades. It turns out that former Treasury Secretary and National Economic Council Director Larry Summers was spot on in spring 2021 when he warned that “I think this is the least responsible macroeconomic policy we’ve had in the last 40 years.”

What is the reason for falling inflation? One explanation can immediately be ruled out. No, the Inflation Reduction Act (a misnomer if there ever was one) did not defeat inflation. For one thing, inflation was already falling before the bill passed in August 2022. Secondly, many of the provisions of the law have yet to go into effect. In fact, the treasury department and IRS just released guidance on some of the significant provisions of the Inflation Reduction Act just last week—nearly a full year after the bill’s passage.

The idea that the Inflation Reduction Act was going to reduce inflation has always been implausible, seeing as its tax hike provisions constrain supply, and its supposed deficit reduction does not begin to take place until 2028. The law increases deficits in the years 2024–2027. More artificially stimulated demand and constrained supply is not a recipe for bringing down inflation. If anything, the Congressional Budget Office is likely taking an overly sanguine view by saying that the law will have a negligible effect on inflation.

Instead, the Federal Reserve’s interest rate hikes and the expiration of American Rescue Plan Act provisions are likely the key factors behind the decline in inflation. Broadly speaking, there are essentially two ways to bring down inflation: reduce spending demand or expand the supply of goods and services. The second approach is preferable in that it simultaneously allows for lower inflation and higher economic growth, but the types of regulatory and tax policy changes needed to expand supply would require consensus in Congress and the White House abandoning the anti-growth policy agenda pushed by many progressives.

The first approach (reducing demand) is what the Federal Reserve has pursued. As the Fed raises rates, borrowing becomes costlier, which makes it less attractive for consumers to purchase things like houses, vehicles, and appliances using credit. Higher interest rates also make saving more attractive. The result: consumers pull back demand. Similarly, the expiration of stimulus from the American Rescue Plan Act reduces overheated demand while the expiration of anti-work provisions removes part of the straitjacket imposed on supply.

Is the falling inflation a surprise? Prognosticators have been all over the map with their inflation forecasts during the past two years, but it ought not to be surprising that inflation would come down once the Federal Reserve finally began to take action and hike rates. At the beginning of the year, soon after the release of the December 2022 inflation data, I published a blog post with a forecast of where inflation might be headed in the first half of 2023. In the spirit of accountability, the figure above shows my inflation projection through May 2023 compared to how inflation has actually played out in reality.

The red (projection) and blue (actual) curves track each other remarkably well in 2023. In fact, my earlier blog post stated “topline year-over-year inflation readings are set to fall rapidly over the next several months—possibly even falling below 4% by early summer.” As a reminder: the May inflation rate came in at exactly 4%. Although my projections were mildly on the optimistic side, they have mostly held up.

Does that mean inflation is no longer a problem? Quite the contrary. The figure below shows that higher prices have essentially been locked in. The Federal Reserve is not even attempting to bring prices down. It is just trying to moderate the future pace of price increases to historic norms. Unfortunately, purchasing power is still more than 3% lower than it was at the beginning of 2021, as shown in the figure below. Until wages start to consistently outpace prices, workers will continue to suffer from the lingering effects of the inflation surge. Here, too, the economy faces serious headwinds, considering that labor productivity is on the decline. But addressing the low productivity crisis is a topic for another day.

Where do we go from here? There is no such thing as almost landing an airplane. You either land it, or you crash. In this case, the Federal Reserve has one task: to land inflation at 2% sooner rather than later. The longer it takes to achieve the 2% target, the less inflation-fighting credibility the Fed will have as people start to accept a persistently higher inflation rate as normal, which will make the Fed’s job even more difficult.

While the headline inflation number is moving rapidly in the right direction (and will likely continue to do so at least for one more month), some of the components of inflation are still concerning. In particular, core inflation (which excludes food and energy) is falling much more slowly. The latest core inflation rate from the CPI report is 5.3%, which is only modest progress from the 5.6% rate from the start of the year. One glimmer of hope is that housing costs have been a significant recent driver of inflation, but the data are lagging. Because most people who rent sign one-year leases, large rent increases from several months ago when conditions were different in the rental market still affect current inflation readings. As tenants begin to roll over into new leases, the data should adjust and likely show a slowdown in rent increases.

The bottom line is that the inflation picture has improved, but we are arguably entering a murkier phase over the next several months. The Federal Reserve made clear in its statement regarding pausing rates that it was likely not done raising rates. Rather, the pause is an opportunity for more data to come in to guide future actions. But one thing is clear: the mission is not yet accomplished.

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What is the debt ceiling, and what would have happened had we not raised it?

The debt ceiling (or debt limit) is a legal limit on how much money the U.S. government is authorized to borrow. Once the country reaches this limit, the Treasury is not permitted to issue more debt.

Can we simply not raise the debt limit?

The Congressional Budget Office (CBO) projects that the federal government will run a deficit of more than $1.5 trillion in 2023 alone, with spending amounting to $6.4 trillion and revenue coming in at $4.8 trillion. Of the $6.4 trillion in spending, $4 trillion is for mandatory programs that operate without Congress needing to regularly reauthorize them (e.g., Social Security and Medicare), $1.7 trillion is discretionary spending, and $660 billion goes to interest payments. Balancing the budget and eliminating the deficit in one fell swoop would require essentially zeroing out discretionary spending or making instant, draconian cuts to mandatory programs. Given the deep fiscal hole that the federal government has put the country in, there was no real alternative to raising the debt ceiling.

If both sides agreed that the debt ceiling had to be raised, what were the negotiations about?

Historically, occasions when the government has reached the debt ceiling have produced negotiated agreements that both raise the ceiling and limit spending, as was the case with the Budget Control Act of 2011 during the Obama-Biden Administration. However, this time around, the White House insisted for months that it would not negotiate on any spending reforms as part of raising the debt ceiling.

Given the unsustainable fiscal path that the United States is on, the White House was essentially sending the message that the only way to avert a debt crisis now (by raising the debt ceiling) was to cement the current spending trajectory in place—and thereby increase the chance of a debt crisis down the road. The House of Representatives disagreed with this false choice between a debt crisis today and a debt crisis later and instead passed the Limit, Save, and Grow Act, which simultaneously raised the debt ceiling and slowed the trajectory of spending, among other reforms. Passage of this bill forced the White House to the table, abandoning its no-negotiations stance on spending reforms.

What is contained in the debt ceiling deal?

The debt ceiling deal contains a number of elements. First, it raises the debt ceiling through the end of 2024 and it establishes spending caps for fiscal years 2024 and 2025 that limit the growth of spending to 1% with tough enforcement provisions during the appropriations process, which is when Congress formally makes detailed, program-level spending decisions. In addition, the bill prescribes a 1% cap on spending growth through 2029. By way of comparison, the CBO projected an 8.1% jump in discretionary spending between 2024 and 2025, followed by average annual increases of 2.8% through 2033.

Besides affecting topline spending, the debt ceiling bill rescinds certain COVID-19 and IRS funds, expands work requirements for food stamps and welfare, and implements energy-permitting reforms to reduce delays from excessive and unresponsive bureaucracy.

What is the overall effect?

The CBO projects $1.5 trillion lower spending growth (or in Washington, DC parlance: cuts) because of the deal. Without the deal, discretionary spending would have risen from $1.7 trillion in 2023 to $2.4 trillion in 2033, whereas now the projection is for $2.2 trillion in discretionary spending in 2033.

To give further perspective, the figure below plots three different projections for the path of discretionary spending as a percentage of the country’s annual economic output. The blue dots are CBO projections made in fall 2019 under the previous administration and before COVID-19. The orange dots are CBO projections from this May, but before the debt ceiling deal. The red arrow showing the upward shift from the blue dots to the orange dots represents the persistent increase in discretionary spending under the current administration’s policy plans. The gray set of dots represent discretionary spending under the debt ceiling deal, with the green arrow showing the reduction relative to what was slated to occur before the deal.

As the figure makes clear, the debt ceiling deal essentially takes discretionary spending halfway back to the path it was set to follow before COVID-19 and the change in administration.

Figure 1: Discretionary spending as a percentage of GDP. Source: Congressional Budget Office, Show-Me Institute calculations.

How should Missourians view this deal?

The United States faces a profound and troubling fiscal situation with its unsustainable spending levels, not to mention slow economic growth, declining productivity, and inflation that remains much too high. It is important to recognize that the country has a spending problem, not a revenue problem. Federal revenues are currently above historical average, but the reason deficits are so large is that spending as a share of GDP is higher than it has ever been over the past century except during peak COVID-19 and World War II. The debt ceiling bill does not fully reverse the spending increases of the past two years, but it represents a step in the right direction, especially compared to the White House’s previous no-negotiations spending stance.

Taking a step back, whereas the debt ceiling debate focused on discretionary spending, the vast majority of federal spending goes to mandatory programs, chiefly entitlements. The CBO projects that, absent reforms, federal spending will rise from 23.7% of GDP in 2023 to over 30% by 2053, annual deficits will more than double to over 11% of GDP, and the national debt will balloon to almost 200% of GDP. In this scenario, interest payments on the debt would triple as a share of the economy and would represent the single largest spending item for the U.S. government. Even this scenario is rosy in that it assumes an infinite willingness among investors to buy U.S. debt regardless of how dire the fiscal picture becomes—a rather implausible assumption that America would be wise not to test.

Going forward, much work remains to be done to right-size government and revitalize economic growth so that Americans can enjoy a more prosperous future free from the risk of steep tax hikes, crippling inflation, debt crises, and adversarial foreign governments buying up large quantities of government debt. The debt ceiling deal is by no means a cure to the country’s current fiscal ills, but it’s one step in the right direction, and the starting point for a much-needed national conversation.

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First of all, consumer spending is holding up. After only growing by 1.3% in the first quarter of 2022, it ended the year growing at a 2.1% clip—hardly robust, but clearly in positive territory. Consumers have been slammed by high inflation and eroding purchasing power for the better part of two years, but the steady job market and still-elevated checking account balances of households have managed to keep them afloat. Unfortunately, so too has rapid growth in credit card utilization, which may act as a source of financial vulnerability for consumers going forward as they grapple with continued interest rate hikes. Transitions into credit card delinquency are already on the rise, driven especially by households in the 18–29 and 30–39 year age ranges.

Switching gears, gross private domestic investment declined notably in the third quarter of 2022 (9.6% on an annualized basis) but increased by 1.4% in the fourth quarter. On the surface, this turnaround is good news. However, peeking beneath the hood reveals some reasons to be cautious. Most strikingly, residential investment fell by 26.7% as the housing market gets pummeled by the rapid rise of mortgage rates over 2022. In the first week of January 2022, the average rate for 30-year fixed-rate mortgages sat at 3.2%. In the last week of December, it was at 6.4%. Such a huge increase in rates translates to a jump in monthly payments of over $800 for someone buying a $400,000 house with a 20% down payment—making it more difficult to qualify for a loan.

Looking beyond the housing market, nonresidential fixed investment increased by an anemic 0.7% on an annualized basis in the fourth quarter after growing by 6.2% in the third quarter, a sizable deterioration. As a result, fixed investment overall fell by 6.7% on an annualized basis in the fourth quarter, which is even worse than the 3.5% decline in the third quarter. So how is it, exactly, that private investment still increased by 1.4% overall? The answer: inventories increased, which is far less important for economic growth in 2023 and beyond than businesses confidently investing in new factories and capital.

So what does all this mean for 2023? Unfortunately, not much. The good news is that the economy is not crumbling—at least not yet. And there are also reasons to be hopeful that the Federal Reserve’s interest rate hikes are finally breaking the back of inflation despite the federal government’s fiscal profligacy since the beginning of 2021. However, interest rates are still on their way up, consumers are borrowing more, gas prices are on the rise again, and the housing market is stalling out, with very real prospects of modest to moderate house price declines in at least certain pockets of the country. None of these trends bode well for consumer sentiment or small business optimism. But there’s still a chance that the Federal Reserve can manage to thread the needle, and divided government in Washington, D.C., means that more blowout inflationary spending packages are less likely. It’s certainly something worth crossing our fingers about.

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Beginning in early 2022, the Fed initiated a rate hike campaign that, to date, has taken the federal funds rate (which influences other interest rates in the economy) from 0% to over 4%. We now have evidence that the Fed’s rate hikes are beginning to bite. Consumer price inflation peaked in the summer of 2022 at over 9% and has been on the decline ever since, most recently hitting 6.5%. This lag between rate hikes and inflation dropping is common. Moreover, because the monthly inflation increases were so high in the first half of 2022 and have been considerably lower over the past few months, the topline year-over-year inflation readings are set to fall rapidly over the next several months—possibly even falling below 4% by early summer. The figure below visualizes a plausible path of inflation over the next few months.

If this projection comes to pass, it would of course be very good news for families’ pocketbooks. Keep in mind, however, that inflation is declining despite the federal government continuing to spend too much money, and not because of any of the recently passed legislation. Absent the spending binge of 2021 and 2022, the United States would almost surely not have seen the decades-high inflation that has robbed families of precious purchasing power—an erosion shown in the figure below. Since the passage of the American Rescue Plan Act in early 2021, consumer prices have risen cumulatively by nearly 14%. During that same period, worker earnings have increased by less than 10%. This four-point gap marks a significant decline in purchasing power that is showing no immediate signs of reversing.

By contrast, if one looks at recent history—namely, the period between early 2017 and the beginning of the COVID-19 pandemic—earnings noticeably outpaced inflation, as shown in the figure below. In fact, inflation-adjusted median household income jumped by the most on record during that period, just as poverty rates hit historic lows. It is worth pointing out that economic gains of that size were not expected. Instead, the economy outperformed earlier projections from the Congressional Budget Office made prior to the pro-growth tax reforms passed in 2017 and the concerted effort across federal agencies to streamline and reduce the burden of regulations.

Looking forward, the good news is that inflation is likely to continue falling, and possibly at a faster pace over the next few months. Producer price inflation is also moderating, with the most recent core reading (which strips out volatile components related to food, energy, and trade services) coming in at “just” 4.6% year-over-year. However, it is important that we do not move the goalposts and lower the bar for victory. The objective clearly stated by the Federal Reserve—and to which Americans have become accustomed over the past few decades—is inflation that is 2% or less. For this reason, nobody should expect the Federal Reserve to immediately stop hiking rates—let alone begin to cut them—until inflation falls below the 2% threshold and stays there for a while. The Federal Reserve has signaled this much in its recent communications.

Of course, the timeline for finally taming high inflation could be significantly accelerated with a pro-growth, supply-side agenda that unleashed the productive capacity of the U.S. economy whereby businesses could meet demand without raising prices. If we conceptualize inflation as too much money chasing too few goods, one approach to reducing inflation is to take money out of the economy—exactly what the Fed is doing right now—while the other approach is to ramp up the amount of goods and services the economy produces. In light of divided government, substantial tax and regulatory reform is unlikely, but on the positive side, massive partisan tax hikes and spending bills are unlikely too. Inflation relief is (likely) on the way, but it is important to understand how we got here so we don’t end up making the same mistakes again.

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A year later, in January 2023, a lot has changed, but some things remain the same—especially the amount of economic uncertainty on the horizon. The economy began the year with rock-bottom interest rates, but after the Federal Reserve finally came to terms with the persistence of inflation, it wisely abandoned its lax stance and proceeded to tighten the screws by raising interest rates at an extremely rapid pace—taking its benchmark Fed Funds rate from 0 percent at the beginning of the year to over 4 percent by the end. During this same period, mortgage rates jumped from historically low levels of under 3 percent to over 7 percent. As a result, existing home sales fell by 35 percent over the year, and residential investment plummeted. Meanwhile, gross domestic product shrank during the first two quarters of the year but managed to register a respectable number in the third quarter (fourth quarter data is not available yet).

The primary questions on everybody’s minds entering 2023 are these: Can the economy achieve a soft landing? And can inflation come down without the U.S. economy entering recession? Unfortunately, it is still far too early to tell. Today’s jobs report revealed that the labor market continues to hold up, with payrolls growing by 223,000 in December 2022 and the unemployment rate falling to 3.5 percent. While these data are good news, they don’t tell us much about the future, because the labor market tends to lag the rest of the economy. In other words, if the U.S. economy hits turbulence in 2023 and enters recession territory, the labor market response will likely be delayed, as has been the case historically. In the meantime, the main takeaway from the most recent jobs report is that the prospects for the Federal Reserve reversing its rate hikes are basically nil—at least until inflation drops back down to 2 percent and remains there for a while. The recent release of the Federal Reserve’s minutes from its most recent policy meetings confirms that there is no sentiment at the Fed to begin rate cuts anytime soon.

It is still possible to gather some other tea leaves from some of the recent economic data, however, to get a sense for where the economy may be headed. The downside of the latest jobs data is that there is little to no evidence that workers are being enticed from the sidelines. As shown in the chart here, the labor force participation rate—which counts people who are working and those actively looking for work—remains below 2019 levels by a full percentage point. Some of the drop is due to early retirements during COVID-19, but if one looks at the data just for prime-age workers (those between the age of 25 and 54—see the chart here), their labor force participation rate hasn’t fully recovered either. With 1.75 job openings per unemployed worker, the labor shortage has no imminent end in sight, which also complicates the inflation picture by making it more difficult for businesses to accommodate demand without raising prices.

Thankfully, the end of 2022 offered some promising signs for inflation. Most directly, the inflation data itself showed some moderation, although it continues to run hot at over 7 percent year-over-year. Also, the most recent jobs report showed that wage pressures also may be subsiding to some extent. Of course, faster wage growth in principle is a good thing for workers, but only when driven by sustainable forces. Over the past nearly two years, wage growth has run hotter than in prior years, but the increase took place amidst a backdrop of declining productivity. The result has been even faster price growth, resulting in a steep drop in purchasing power, leaving families poorer in terms of their living standards. Going forward, 2023 offers a lot of uncertainty, and data over the next few months regarding inflation and productivity will be quite revealing. One thing working in the economy’s favor is a divided Congress, which should mean a stop to the glut of inflationary government spending. The question is whether it will be too little, too late to avoid a hard landing.

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