The threat of an upcoming recession shouldn’t worry states and local governments who’ve already weathered COVID-19 related shutdowns, as many local governments are in the best fiscal shape they’ve ever been in.
That’s according to panelists gathered on Wednesday for The Volcker Alliance and the Penn Institute for Urban Research’s briefing on inflation and recession for states and cities.
“Given the ample rainy day funds that states have been able to accumulate and obviously a large part of that is due to the federal government support that has been provided throughout the pandemic in lots of different ways, directly and indirectly, states and localities are in about as good a shape as they have ever been coming into something like this.” said Mark Zandi, chief economist at Moody’s Analytics.
Fannie Mae updated its economic forecast yesterday to note that a “modest recession” is expected in 2023. Zandi said he respectfully disagreed with that forecast, adding that he believes the U.S. economy will ultimately land with positive growth at the end of 2023. States and local governments have an important role to play, Zandi said.
“That does give me some solace that in fact the economy will be able to evolve into self-sustaining economic expansion that state and local governments can help support the economy through what will be a bumpy period,” Zandi said.
Aside from federal stimulus, state and local governments have also done well at withstanding the COVID-19 challenges due to two key factors, Natalie Cohen, president of National Municipal Research said.
“The Supreme Court’s recent Wayfair decision which allowed state and local governments to charge sales tax on internet purchases, collided with the lockdowns and the need to stay at home and equip your work from home and your school from home facilities added to a significant unexpected growth in sales tax,” Cohen said.
“The second trend that took place was the migration of people who had the means to leave dense urban and suburban areas and move to less dense cities and also less dense exurb and rural environments that also collided with limited supplies for construction,” Cohen said.
“Housing prices have gone up significantly and along with that, property taxes to local governments.”
Cohen believes these factors also helped to stave off defaults that might have otherwise happened. But drops in municipal market activity and the rise in interest rates is also some cause for concern.
Municipal market volume over the past two years topped $480 billion but isn’t expected to reach anywhere close this year.
“Some of this was driven by higher issuance of taxable municipal bonds, which was largely due to the low interest rates which are disappearing,” Cohen said. “This allowed municipalities to advance refund their tax exempt bonds with taxable debt and achieve savings for their budgets,” she added. “So taxable debt increased significantly over the last two years but debt issuance is already showing that it’s coming down quite a bit.”
In Q1 2022, total issuance of taxable municipal bonds was down 10% in January, 19% in February and 18% in March, according to Cohen, and lower volumes are expected for the remainder of the year.
“I would not be surprised to see significantly lower volumes through the rest of 2022.” Cohen said. “ Maybe we’ll end up $100 billion lower than last year, somewhere in the $350 billion range.”
States and local governments are, almost without exception, having a hard time filling positions, Cohen said, and are still not back to pre-pandemic employment levels. Matt Gress, budget director for the State of Arizona said that his office has included $200 million for wage increases in this year’s governors’ budget, a theme seen across the country in various forms.
Some of those increases are being offset by vacancies, Cohen said, and are leading to other pitfalls for local governments.
“These wage gains are going to create another financial challenge for state budgets around our pension systems where the actuaries have failed to account for the abnormally large gains in wages causing funds and their unfunded liabilities to increase,” Gress said.
“The risk is further exacerbated in monetary policy aimed at taming inflation,” Gress added. “If the stock market suffers due to higher rates from the Fed, then you’re going to see similar impacts on pension underperformance, which in turn creates higher unfunded liabilities, which requires states to raise their contribution rates to begin driving those down.”
Pension risk, or the risk that the costs of pensions and other post employment benefits can grow to such a degree that they could crowd out an issuer’s ability to provide services and in extreme case, to even cry out the ability to pay debt service, and should be on the mind of state treasurers, Les Richmond, vice president and actuary at Build America Mutual.
“If salaries increase at a greater rate than what the actuary is expecting, that would raise plan liabilities,” Richmond said.
But panelists agreed that whether budgeting for employees, or planning the costs of new infrastructure projects, doing so is much harder in a high inflationary environment that we’re experiencing currently.
“Planning a capital budget is a lot trickier with such inflated costs for construction materials, construction workers, or whatever the contractors are going to be charging,” Cohen said. “So I think long-term capital planning is just a lot more difficult in this kind of an environment.”