Of course, a slowing economy can be expected to be accompanied by softening tax revenues, and that has been reported in some states already. Nonetheless — and absent the usual unforeseeables like new wars, oil shocks and pandemics — public finance is returning to something resembling business as usual. With a few exceptions, the "New Normal" is becoming the "Old Normal," at least for budgeting, collective bargaining, pension funding, tax rates and debt issuance.
Wall Street has come to a growing consensus that the economy is gliding to a “soft landing,” with the only question being how long this can last. Inflation likely won’t drop in 2024 to the Federal Reserve’s target of 2 percent, so while interest rates will likely drift somewhat lower, don’t look for anything near the unusually minuscule levels that prevailed before and during the COVID-19 pandemic. Borrowers will still pay and investors will still earn a positive real rate of return on debt instruments. Mirroring that overall economic glide path, upward pressures on salaries are likely to ease. But labor markets nationally will remain tight by historical standards, making it an ongoing public-sector challenge to hire personnel amid tight budgets.
And yet, as always, there are counter-indicators: One recent and reliable measure — cardboard prices, of all things — suggests that the economy may remain stronger than market pessimists fear. This “nervous Goldilocks” outlook — economic porridge that’s neither too hot nor too cold — supported a year-end rally in bond and stock markets that at least helps keep public pension plans on track for stable payroll contribution rates, to the relief of budget officials. (The only Grinch that showed up before the recent holidays was health insurance premium costs, which continue to outstrip the CPI by a factor of 2x or more.)
While longer-term bond yields have declined dramatically, by about 1 percent in recent months, it’s unlikely that those returns to investors will fall too much more in 2024. The Fed probably won’t stop selling bonds from its portfolio for many months, until the bloated money supply (M2) is back in line with its non-inflationary long-term trendline through the central bank’s continued quantitative tightening.
This unfolding process will allow the yield curve, which is currently inverted, to eventually normalize, with short-term rates falling to levels below the longer-term maturities sometime in the next 12 to 15 months. Such a lower-rates normalization process will be challenging for public-sector cash managers who have enjoyed a free ride on the yield curve in recent months, when short maturities paid the highest yields with the least market risk.
Those who presciently locked up higher rates by extending maturities before Thanksgiving have outperformed others, but that play is now history: The Fed’s overnight rates may fall by 1 percent this year, but the Treasury notes maturing later in 2025 already anticipate that, and their market yields already trade at a level below shorter rates. This now discourages foresighted public treasurers from extending portfolio maturities too aggressively.
Dabbling With Dollars
In 2024, many local government investors will be satisfied to park cash in their state or county treasurers’ investment pools, which have ultra-low management fees, if any, and can now provide complete liquidity while dabbling selectively and opportunistically in longer maturities as interest rates drift lower. It’s the opposite of the “wronger for longer” strategies that some money-losing pool operators experienced in 2022. This should be the one stage in market cycles when these unregulated investment pools can outperform commercial money market mutual funds — without burdening their stakeholders for foolish maturity extensions that some were prone to make when rates were ultra low.
By year-end, short-term rates should remain well above inflation, while 12-month inflation measures will be very unlikely to glide down toward 2 percent. More likely, the mainstream CPI index will get even stickier as it saunters gradually below 3 percent, given continuing salary and wage increases for workers and unions still trying to catch up from the double-digit 2021-22 inflation scare. It’s hard to imagine an inflation-wary Fed letting its benchmark overnight rates drop to levels of less than 1 percent above the 12-month inflation statistics, which puts a floor under the level and slope of the yield curve this year.
Add to that the new incentive for Treasury Secretary Janet Yellen’s debt team to push more of their monthly and quarterly auction paper into longer maturities at lower rates than short-term T-bills; they’d be crazy not to sell billions of bonds in the face of a steeply inverted curve this year, if the market will swallow it. That’s why bond investors will be disinclined to buy 3 percent Treasurys in light of the relentless rate of federal borrowing and the expanding mountain of Treasury bonds — at least until it’s obvious that the next recession is knocking at the door and T-bonds become a safe haven, which is hopefully several years away.
That said, conventional fixed-rate mortgages slowly inching closer to 6 percent by Thanksgiving seem plausible as their spread over Treasurys shrinks grudgingly, which will help home sales and thus the property tax base in coming years.
Muni Bond Strategies
To boil all that contextualization down to a few words, my base case for year-end 2024 is a Treasury yield curve that is flat around 4 percent for most maturities, both short and long. That’s a far more precise, calibrated forecast than the typical two-handed economists’ equivocating projections.
In today’s municipal bond market, some issuers of tax-exempt paper are considering variable-rate bonds, in anticipation of lower yields on the short end of the curve. Before plunging into that strategy, however, their staffs should give thought to what happens in the next business cycle, when the market’s entire interest rate structure could shift higher as Congress continues to play ostrich with its compound interest debt service problem.
Given the recent 70 basis point decline in long muni rates, it may be smarter now to just lock in for the long haul. Variable-rate paper might work well for a clever superstar public financier for a few years but then leave one’s successors and taxpayers holding the bag in the 2030s. If nothing else, yield curve scenario analysis and full disclosure to oversight officials is advisable for those now attracted to the variable-rate game.
Speaking of Congress, this will be a good year for state and local officials to start preparing for the quadrennial tax battles that are inevitable in 2025, after this November’s elections. The 2017 tax cuts are due to expire then and revert to pre-Trumpian levels. Congress will have to face up to cranky taxpayer groups, and from the noise emanating from tax-hating conservatives these days, it’s likely that spending cuts will be on the table in one or both chambers.
The National League of Cities has already begun preparations for the post-election skirmishes, and it will be important to prepare a strong defense as well as an offense. I struggle to think of ways the next red-ink Congress will be inclined to hand out more intergovernmental appropriations to states and municipalities, barring a deep recession. Pragmatists and realists already worry more about tax committee takeaways in the muni bond market than they dream of deficit-financed sugar plums for governors and mayors. Either way, this is the year to get organized and huddle with the national association staffers who work inside the Beltway. Best to be realistic and battle-ready.
Rethinking Reserves
This year’s cautiously optimistic fiscal outlook is likely to set the stage for state and local officials to consider ways to rethink their long-term financial reserves in search of better ways to deploy liquid fund balances. For some, of course, this is ultimately just air cover for raiding the cookie jar to spend one-time money for other purposes, which is seldom a wise idea. Already California officials are eyeing their reserves to avoid layoffs that are driven by a capital gains tax revenue shortfall, not a recession.
Several states have reported success in preparing long-term financial forecasts and stress tests, to guide elected officials who are keen to promote splashy tax and spending policies without looking beyond the next year. Before going too far down an uncharted fiscal rabbit hole, CFOs and budget officers need to map out the likely trends and scenarios that could unfold in coming years. That includes an honest quantification of the local financial consequences of a future recession of various degrees.
Presently, there do not appear to be enough excesses in the economy to trigger such a swoon in the near future, but there are always those exogenous factors — those wars, pandemics and oil shocks — to consider before cutting taxes or spending reserves for recurring operating costs. A long-term budget model that includes a shallow one-year recession in the 2027-28 time frame is well worth running as a realistic “base case.” And it won’t hurt to also run one “black swan” model to simulate the fiscal consequences if, for example, Venezuela invades Guyana and drags the U.S. into a brief armed conflict.
If a thoughtful review of insurable and foreseeable risks does yield fruit for fiscal redeployment of rainy-day reserves, then public officials should ask whether they have established and properly funded an actuarial reserve for their retirement medical benefits promises. At least half the public-sector jurisdictions in the U.S. have never advance-funded their “other post-employment benefits” plans, and among those that have, over half are grossly more underfunded than those jurisdictions’ pension systems.
One of the hidden benefits of an OPEB trust fund is that, unlike a pension fund — which typically exists outside of the employer’s reach for clawbacks — an OPEB trust can be structured sensibly and strategically in ways that allow employers to redirect annual contributions and benefits payouts when revenues shrink, without endangering head count, services and promised pension benefits. Stronger OPEB funding policies will also appease the bond rating agencies, which in turn could reduce future borrowing costs. It’s a rare case in which elected officials can have their cake and eat it too.
Protecting and Pricing Public Data
My final column of 2023 explained the importance of anticipating and protecting the value of digital public information that could eventually yield commercial profits and public-sector revenue in this new age of artificial intelligence. Already municipal zoning at the parcel level has been assembled in databases for commercial use by AI entrepreneurs serving real estate brokers and property developers.
State legislators also will have their work cut out for themselves in the next year or two as the commercial freedom-of-information lobby pushes hard at state capitols for low-cost access to public information that is not even compiled in document form today. To AI entrepreneurs, unassembled raw data is a potential gold mine — or at least copper — and demand will accelerate, especially when public officials figure out the ground rules and the trade associations start to show the results of pilot programs using public-sector digital information for a host of applications. Canada’s government has recently addressed the monetary value of public data ingested from the news media industry, but even our northern neighbors appear to have given little thought to the property rights issues of public-sector information.
As we look into 2024, it’s a worthwhile New Year’s resolution for public officials at all levels of government to acquaint themselves with the inevitable issues — and opportunities — that will arise from this new technology in the public sphere. Congressional lawmakers are already behind the AI learning curve, and there’s no reason to think that state and local officials are ahead of their federal counterparts.
No doubt there eventually will be important productivity gains in some sectors of public service as this new technology comes online. It’s possible that some public employees will be able to do more, faster, using AI tools, and the resulting cost savings should help the budgets of larger jurisdictions, but it likely will be at least a couple of years before prototypes evolve into mainstream applications. HR departments will need a modest AI training budget before that vision becomes commonplace.
It’s already clear that some of the benefits of AI will serve only some of a jurisdiction’s populace, which raises all kinds of policy and pricing issues. What are the functional responsibilities of municipal governments when technology makes feasible new services that cannot and should not be supported by taxpayers at large? Some of the classic lines between public goods, social goods and merit goods will be tested by such technology in coming years, and given the implications for public finance, 2024 will be a good time to start having those conversations.
Governing's opinion columns reflect the views of their authors and not necessarily those of Governing's editors or management. Nothing herein should be construed as investment advice.
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