Inflation’s eruption: Although global pandemic-generated supply chain interruptions and Russia’s invasion of Ukraine certainly didn’t help, the seeds of America’s inflation problem date back to 2021’s injection of fiscal and monetary stimulus to counter the COVID-19 shutdowns. The U.S. money supply surged, as my 2022 New Year’s column pointed out, and too much cheap money sloshed around the economy, chasing too little stuff including housing. Inflation rates unseen in 40 years erupted, and that caused bond and stock market reactions, unprecedented public-sector cash management blunders, pension fund headaches and public employee compensation issues.
The Federal Reserve has been playing catch-up all year, but clearly put a stop to excessive growth of the money supply by using its two key policy tools: rocketing short-term interest rates and a monthly liquidation of the bloated bond portfolio the Fed had built up in 2020-2021 in efforts to forestall a COVID-induced recession. As a result, the widely followed M2 money supply chart has leveled off over recent months, and monetarists expect that continuation of that discipline will eventually bring inflation rates lower, moving them toward the Fed’s long-term target of 2 percent. Services disinflation is sticky downward and intertwined with payroll expenses; happily, unit labor costs in the private sector have decelerated to a 2.4 percent rate in the latest quarter. That says we’re on the right track, although it’s a slow track and still a long haul from the terminus.
Nonetheless, inflation is not dead, even though the prices of certain goods may actually drift downward. Producer prices still inflated at an annual rate of more than 7 percent in November, hardly a credible sign of deflation. Also, ours is now a predominantly services-centric economy, and escalating wages for the workforce will continue to drive expectations of price increases for at least another year. Although Americans probably won’t see a long decade of 1970s-style inflation this time, salary inflation now faces state and local employers, budgeters and pension systems.
Rising interest rates: Once the Fed finally came around to combating the inflation monster, it rapidly pushed short-term interest rates higher, and the bond market followed suit in the longer maturities. The yield curve, tracking issuers’ returns to investors, surged upward and caught many public treasurers and investment officers in the trap they set for themselves last year by extending their portfolio maturities far too long in a futile, naïve and desperate quest for fractionally higher interest rates. That was a multibillion-dollar mistake. Surging money market interest rates quickly outran them.
The result was unprecedented market-price losses in some state and many local government cash portfolios. In California, a whopping $8.7 billion — about 24 percent of the state treasurer’s local agency investment pool participants’ April balances — has since run for greener hills as no-brainer Treasury bills began to pay far more than the state’s mismanaged pool fund. My October 2021 column on disintermediation anticipated this potential for misery, and the state’s stakeholders are holding the bag because the megabillion market losses are now left for them to suffer. The Golden State treasurer fittingly gets my 2022 Wrong-Way Riegels Award (of Rose Bowl lore) for its investment pool’s misdirection, but billions of lost investment income also now sit sunken in the underwater portfolios of dozens of local government treasurers and professional cash managers who blithely ignored repeated warnings. Arguably the most shameless were a handful of profit-seeking outsourced money managers of public funds who persistently claim to deliver expert active trading acumen — which quite obviously did not exist at any time in 2022.
Rising interest rates also had their impact in the municipal bond market. The saddest stories are those of municipalities that failed, when they had a chance at the beginning of the year, to complete obvious lower-rate refinancings of old high-coupon debt. My 2022 Rip Van Winkle Award goes to the elected leaders of Richmond, Calif., where staff and financial advisers had repeatedly urged a $134 million pension bond refunding deal. It never got off the ground until it was too late, catching the attention of the state auditor as reported last month by Bloomberg. But now that’s all spilt milk. The only refunding bonds we see lately are for higher-coupon debt sold a decade ago that has just now become eligible for scheduled optional redemption and replacement, for more-modest savings. Meanwhile the cost of borrowing for infrastructure has made public improvements more expensive for taxpayers, although a year-end muni bond rally has lately provided a little rate relief.
The happier news for municipal borrowers is that 2023 should eventually end up with a better rate outlook, once the Fed slays — or at least hobbles — its inflation dragon. But lower muni bond yields are unlikely until the Fed can see the tail end of its multiyear Treasury bond runoff, which is a big deal to monetarists. Meanwhile, short-term temporary financing has its charms, for technical reasons I explained two months ago. The muni market’s next problem will be deteriorating credit ratings, not interest rates, along with an increase in expected issuance in the second half of 2023.
The U.S. Treasury yield curve has inverted, which talking heads associate with future recessions, but maybe this time it’s different — emphasis on “maybe.” Thankfully, though, the muni bond yield curve has not inverted, making short-term borrowing still favorable vs. inflation, and a way to buy time until rates do decline.
Buoyant budgets: Overall, state and local government budgets have benefited from inflation on the revenue side. Despite Fed rate-tightening, the U.S. economy kept expanding. In fact, it performed better than many economists expected. Income- and sales-tax revenues have held up well throughout the year; capital gains taxes were another story, and a painful one for states like California that depend heavily on that more volatile revenue source. Sales tax collectors don’t care so much if unit volume is down so long as price tags go up, as they have, which is why this major revenue line item has held up — albeit a bit lower than some optimists had overbudgeted. Property tax assessments are mostly still a year behind fair market value despite the recent buyers’ strike, so for now most localities remain unscathed by the doubling of mortgage rates in 2022. Next year will be the time to worry about these revenues, especially if the optimists’ coveted soft landing degrades into a clear-cut recession.
Even without a recession, however, expense and payroll inflation is beginning to compel some belt-tightening nationwide, including in state and local budgets. However, payroll costs are still catching up with the Consumer Price Index, as I explained recently, and deferred retirement benefits expenses will hit public budgets with an even-longer lag, so inflation’s fiscal vise remains a manana problem: Most budgeters have skated by this year with only a few adjustments to their fiscal plans. But that free pass is expiring, and muni credit rating agencies are now keenly on the lookout for budget squeezes and shortfalls.
The temporal corollary to all this is that a good chunk of the fiscal relief for states and localities under Congress’ 2021 American Rescue Plan Act package spilled into this year and became a belated gift that kept giving — whether or not it was needed to offset slumping revenues. By now, though, it’s mostly been spent.
Pension paradoxes: Stock and bond markets deflated the market valuations of public pension portfolios in 2022, but taxpayers won’t get the bill for several years. Actuarial valuations use multiyear smoothing of asset levels, so this year’s shortfall of average investment returns vs. their assumed appreciation won’t hit public employer budgets until 2024 in most cases. On the liability side, inflation is the bigger problem for many systems, as their future retiree costs will consequently exceed prior assumptions. Even where cost-of-living adjustments for retirees are capped or deferred by system policies, the future cost of pensions for incumbent employees is based on their final, eventually inflated pay levels. As a general rule, every dollar of salary increases above 3 percent today will add 10 dollars of unfunded pension liabilities next year. Likewise, the future costs of the inevitable boosting of retirees’ benefits will ultimately bite into the actuarial reserves, with similar mathematical results. Yet this year’s visible, operational pension metrics remained stable despite the highest inflation in 40 years. So enjoy the coming New Year festivities before the actuarial bills come due and payback begins — as it must.
Congressional megabillions: Nothing from Capitol Hill this year actually moved the current balances of state and local budgets, but two bills were signed into law in 2022 that portend well for public financiers hereafter. The so-called Inflation Reduction Act included megabillions of helicopter dollars for infrastructure projects that will shower down on the states and municipalities in the next two years, but little of that money has made its way into local coffers yet.
With the CHIPS Act, Congress also passed a bill to grant lavish new-build incentives to semiconductor manufacturers, and again the financial impact on states and local governments will take far more time than the few months that have elapsed since its enactment. Nevertheless, Arizona and Ohio are already touting their site selections as major companies announce plans to locate large chip-making plants there. This bill and the larger theme of onshoring U.S. manufacturing (away from China in particular) will be a major topic in 2023 as an economic development rat race features intense interstate competition and giveaways for manufacturing facilities. Watch out for costly tax abatement concessions from states and localities trying to lure these giant employers. It’s a windfall for corporations and a prisoner’s dilemma for municipalities.
Looking backward, it must be noted that the 2021 ARPA law showered billions of “counter-cyclical” dollars on the states and localities in both 2021 and 2022, with a notable chunk of that money spent well after the economy re-opened. Critics of federal aid to the states will harp on this “intergovernmental fiscal policy lag” and its alleged inflationary impact for years to come, as cranky conservatives point to the timing of spent and unspent dollars as their vivid proof that the federal largess was never needed in the first place.
This issue is not new, going back to the counter-cyclical aid during the Carter administration. History shows that by the time such federalist aid is actually spent at the local level, the national economy typically is already back on its feet. The state and local policy associations had best hustle to complete some credible research on the beneficial spending actually completed in 2021, before this issue gets away from them. Meanwhile, a divided Congress will be deadlocked to the point that significantly more helicopter money is highly unlikely even if the economy stalls out next year.
Swings and misses: In the spirit of honest self-appraisal, I look back at this past year’s columns and must call out my overblown piece on intergovernmental aid for hosting Ukrainian evacuees. As it turned out, most Ukrainians chose to stay, endure and fight, or to relocate to nearby countries, so only a trickle came to the U.S. Thus, the stress on our local agencies was negligible overall. No need for federal aid there; this never became a domestic issue.
So I clearly didn’t bat a thousand this year, but did score some hits and even some home runs. We’ll have to see how my batting average holds up next year, as the economy pitches us fewer fastballs but more curveballs and sliders.
Governing's opinion columns reflect the views of their authors and not necessarily those of Governing's editors or management.
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