By Girard Miller
State and local finance teams need game plans for two divergent outcomes of the Federal Reserve’s efforts to wring inflation out of the economy: a soft-landing slowdown or a more severe downturn.
“When you come to a fork in the road, take it.” —Yogi Berra
Inflation is now foremost on the minds of most Americans, according to poll after poll. The Federal Reserve board remains keenly focused on curbing inflation through higher interest rate policies. Nobody knows whether the Fed can succeed without crashing the U.S. economy into a recession, and financial markets have already priced in some but not all of the potential economic impact of such an unhappy outcome. Meanwhile, most state and local government budgets are flourishing, with record revenues, even if some of that is arguably the froth of inflation and not real growth. So, what’s next?
The short answer, as far as state and local government budgets are concerned, is stagflation: a period of elevated inflation rates coupled with decelerating economic growth and then economic stagnation nationwide, with scattered layoffs here and there. In the private sector, large companies are already pulling in their horns, with a few of them trimming staff after over-hiring last year. And Wall Street is already feeling a mini recession with stock and bond prices down substantially because of Fed tightening.
Such malaise doesn’t necessarily equate to a general, full-blown recession, but it could lead into one. Yet it’s also possible that the Fed’s tighter-money slowdown drags inflation rates lower to sustainable levels, the economy stabilizes and then glides to a “soft landing” with business as usual for governmental operations. So public-sector budgets, labor negotiations, tax policies, infrastructure plans, treasury portfolios and pension funding are all approaching a day of reckoning within the next 12 months. This requires strategic thinking on two levels, and contingency plans for both scenarios — in other words, for what to do at a likely fiscal fork in the road.
For starters, budgeters can relax about their revenues in the next six months either way, with the two notable exceptions of building permits and income taxes from stock market profits. Meanwhile, lower but stubbornly persistent 5 or 6 percent inflation rates this fall will drive revenues from wage-based income taxes and sales taxes higher, because stagflation is not recession. Despite all of the Wall Street gloom and doom, today’s robust economy won’t likely shrink until it first slows down to stall speed, and the 3 percent interest rates now priced into the market won’t themselves tank the economy in 2022.
That’s the short-term outlook. Longer term, look for interest rates to run up higher than many now expect: Inflation indexes are unlikely to recede from 9 percent to 2 percent overall unless short-term interest rates first crest above 4 percent. Therefore, expect yet more Fed tightening as we go into 2023 and for the yield curve to invert with short-term interest rates materially higher than long rates, not just fractionally as they have been lately. That often signals a recession ahead, but in this case it could still be a false alarm, even though Wall Street pundits will bemoan and yammer about the inverted yield curve for months ahead.
Downside Revenue Risks
What do these interest rate scenarios portend for state and local budgets? For property taxes, higher interest rates will obviously chill the housing market, and home prices will likely soften a bit in many regional markets despite strong underlying demographic demand. Materials and labor costs next year will still be higher than pre-pandemic levels, so replacement costs will still be “sticky upward.” Somewhat higher mortgage rates are easily foreseeable, but given the run-up in rates already seen in that market, they should peak in 2023.
Even so, local governments’ property assessments still have not caught up with this year’s prices, providing a cushion below their revenue base that should sustain operating budgets through 2023. Budgeters should have a pretty good sense by next summer of their 2024 outlook and the magnitude of any downside revenue risks. But if stagflation persists, expect to see property tax insurgencies in a few scattered jurisdictions that offer no protections to residential taxpayers.
As for income tax revenues, states that tax stock market capital gains will continue to see a drop-off from that source, especially in California and New York where CEOs and venture capitalists pay top tax rates when their companies go public. Meanwhile, 2023-2024 sales and income tax revenue stability is at risk only if short-term interest rates have to increase above 5 percent to kill inflation by choking the economy.
Public cash managers will still face market risks if they invest too far out into the future, but the worst will hopefully be priced into the market by early 2023. For debt issuers, the only good thing to say about this forecast is that municipal infrastructure bond yields won’t likely go up as much: Long-term tax-exempt paper at 5 percent should attract savvy income investors, putting a lid on those rates under both scenarios. Pension costs will inevitably increase as a double-whammy result of stagflation, but those impacts will not hit most employers’ budgets until 2024 at the earliest because of accounting and actuarial process lags.
The greatest challenge for most public-sector budgeters, CFOs and government executives in the stagflation scenario will be labor costs and collective bargaining. With revenues continuing to increase and money still left over in local coffers from the federal American Rescue Plan, it will be a tough sell to convince union representatives that they should “take one for the taxpayers” and accept wage increases lower than CPI inflation. Widespread governmental layoffs are not on the horizon this year, and if the overheated economy glides to a soft landing with inflation rates dropping to 4 percent next spring, public employees will enjoy job security. So salary and wage costs will run hot for the next 12 months as contract negotiators focus on their rearview mirror more than the windshield. In fact, public- and private-sector salary increases will likely prolong a wage-profits-price spiral that persists into next summer but wanes later in 2023 as the Fed holds taut on its interest rate leash.
The Fork in the Road
Where my two scenarios will diverge is sometime next spring, when it becomes more obvious just how rapidly — and which of — the CPI inflation rates are trending downward. Today’s inflation monster has two heads: the goods-sector head and the services-sector head. Raw commodities, including both food and energy, are likely to sustain price decreases unless Russian military belligerence escalates or Putin entirely cuts off petroleum supplies to Europe and Ukraine’s worldwide grain exports. We are already seeing prices drop for key materials like lumber, copper, cotton and steel; their supply has caught up with demand.
But services and shelter occupy the lion’s share of the economy, and the housing component of the CPI — which is one-third of the inflation index — has a long statistical lag that has only yet registered a 5.5 percent increase in the past year despite widely reported double-digit increases in rents and house prices. Shelter inflation is now baked into the CPI for months to come. So any hopes of inflation sliding below 4 percent by next spring are still wishful thinking — sure, it’s a theoretical possibility, but inflation is like a noxious weed that is hard to eradicate once it’s taken root.
If a soft landing proves unachievable, then the recession scenario wins out because the Fed will be forced to slam on the brakes while consumers retrench, layoffs mount and markets tank, with all the economic pain that invariably brings to state and local governments, their residents and their workers. That outcome becomes much more likely if CPI inflation doesn’t slide down from today’s 9 percent level to maybe 6 percent by Halloween, because the Fed then would be forced to raise interest rates this winter by far more than the financial markets now want or expect.
But it’s foolhardy to now jump to the conclusion that recession is inevitable. By next summer, the glass could still be half full as the economy bumbles along, feeling out of sorts but slowly regaining its momentum.
What is abundantly clear at this juncture is that managers and budgeters need to wave warning flags in front of any elected officials and spending advocates who just can’t resist channeling newfound inflation-driven revenue dollars to their pet causes and projects. 2022 should be a year to just say no to new ongoing spending, to actively fund those rainy-day accounts just like 37 states are now doing, to manage for the long run, to watch the key statistics I’ve highlighted, and to be suspicious of all the premature and superficial recession-yammering on TV. There is still a fair chance that the bottom will not drop out.
Ponder all this as financial analysis and not clairvoyance. And just in case I’ve misread the tea leaves, remember Yogi’s ageless wisdom: “It's tough to make predictions, especially about the future.”
ABOUT THE AUTHOR: Girard Miller is the finance columnist for Governing. He is a retired investment and public finance professional and the author of Enlightened Public Finance (2019). Miller brings 30 years of experience in public finance and investments as a former GASB board member and ICMA Retirement Corp. president. He can be reached at
Published in the NYGFOA 2022 Fall Newsletter