Inflation could disrupt economy’s ‘soft landing,’ but cities and counties are prepared

After enduring a wild ride through the last two years marked by the COVID-19 pandemic, local and county governments are staring down an unpredictable economic future—with one certainty: inflation. Last week, Fannie Mae, the government-sponsored lender, predicted that tightening monetary policy at the federal level could bring a “modest recession in the latter half of 2023 as we see a contraction in economic activity.” 

The jury is still out on what exactly that could mean for local governments. But while the national economy’s post-pandemic “soft landing” will undoubtedly be disrupted, Mark Zandi, chief economist at Moody’s Analytics said cities and counties are fiscally prepared for whatever comes next.

“States and localities are in about as good shape as they’ve ever been coming into something like this,” said Zandi during a recent panel discussion hosted by The Volcker Alliance, a nonprofit founded by former Federal Reserve Board chairman Paul A. Volcker with a mission of empowering the public sector, and the Penn Institute for Urban Research. The session, “Special briefing on inflation and recession risks for states and cities,” featured an introduction and recognition of Volcker’s legacy by Jerome H. Powell, chair of the Board of Governors of the Federal Reserve System.

Zandi attributed the preparedness of public organizations to “ample rainy day funds states have been able to accumulate” over the last few years, through responsible fiscal management and an influx in federal spending. In contrast to Fannie Mae’s more gloomy outlook, Zandi predicted the U.S. economy would evolve into “self-sustaining economic expansion.” But even so, there will be “a bumpy period” along the road ahead, and governments must be ready to pivot as needed.

In Arizona, for example, Matt Gress, the state’s budget director, said inflation in the Phoenix metro area has climbed over the last year to 10.9 percent, which is three percentage points higher than the national average.

“The typical Arizona household has spent more than $4,500 dollars for the same goods and services over the past 14 months then they would have with 2020 prices,” Gress said, noting housing costs have increased by more than 12 percent. 

On a positive budgetary note, the rising costs have driven up taxable sales. But that’s only a temporary relief for governments, as organizations will feel the impact later with higher labor costs and other price increases. And as local leaders in Arizona move to respond, Gress continued, they face structural challenges. Property tax rates in the Phoenix area automatically fall as prices increase.

Rates can only be increased “through a very public process,” Gress said, predicting that Arizona and other regions with similar laws “are going to see increased pressure in the coming year to provide relief, either in the form of tax law changes, or rate rebates.”

While the pandemic is loosening its grip, Natalie Cohen, a panelist and founder of the National Municipal Research, noted it’s not the only thing driving up inflation. The nation has “experienced a sequence of extreme events,” including “tariffs imposed in the last administration, many of them are still in place,” she said. Extreme weather events have also caused uncertainty, and the ongoing Russian invasion of Ukraine has inflicted ripple effects across the globe, driving up prices in many sectors.

As the federal reserve moves to stabilize the economy via its mechanisms, there will be consequences felt in local budgets beyond a shift in revenue—most notably, in the $4 trillion held in public pension funds.

“Pension risk is further exacerbated by monetary policy aimed at taming inflation,” Gress said. “If the stock markets suffer due to higher rates from the feds, then you’re going to see similar impacts on pension underperformance, in turn, creating higher unfunded liabilities.” This will force states to increase their contribution rate to “drive those down.” Notably, the blow has been lessened because many states and localities have increased pension funding over the last few years.

Another impact, highlighted by William Glasgall, public finance senior director at Volcker Alliance and Penn IUR Fellow, who moderated the session along with Susan Watcher, co-director of Penn IUR, will be felt in the bond market.

“How is this playing out short term, how will it play out long term and what does it mean for issuance and the ability of states, and counties and cities and school districts to raise money for infrastructure?” Glasgall asked. Cohen said she expects to see the current declining trend of municipal bond issuance continue through the end of the year.

Given the amount of federal infrastructure funding that’s been poured into the U.S. economy over the last two years, this could be a big deal. While the Bipartisan Infrastructure Act “does puts $500 billion in new money into the economy,” Glasgall said, “this is over 10 years. It’s a fairly modest contribution compared to the 80 percent of infrastructure investment in this country comes from states and localities.”

If state and local governments aren’t able to borrow “at the rate of $400 or $500 billion per year, there’s going to be less money spent even as costs are going up—do the arithmetic,” he said.

But while there’s a lot to be concerned about, Zandi stressed “There are no major fundamental structural problems in the economy,” he said. “Big takeaway, there is uncertainty; we have a lot of cash: use it wisely and try to prioritize some of those structural reforms—(unemployment insurance) trust fund, rainy day fund balance, paying down any unfunded liabilities with your pension—that will give you financial flexibility moving into some of these uncertain years ahead.”