Meanwhile, state and local government budget squeezes are coming, as softer revenues are expected from income, sales and property taxes. A soft landing for the economy is possible, but there is still a credible risk of worse. By spring, the global economy and business environment will feel like a muddy, mucky Ukrainian battlefield: prepare to slog.
Although it’s now highly probable that the Federal Reserve will soon be able to escalate its overnight Fed funds interest rate to levels higher than the latest core inflation rates, that is just the first salvo in the central bank’s battle to tame the multi-headed inflation hydra. As long as workers expect to see 5 percent pay raises this year, the overnight interest rate needs to hover at that level or above. Whether that pinches pocketbooks enough to auger a soft landing or pushes the U.S. economy into a recession, nobody truly knows. The two most important and encouraging mile markers that I’m now watching are the M2 money supply, which has gone flatline for six months now, and the private sector’s unit labor cost increases, which declined to 2.4 percent in the third quarter. Now, that’s genuine disinflation, which tells me we’re on the right and cautious path.
But there are still far too many exogenous variables, including the Ukraine war, Putin’s manipulative meddling with petro and grain supplies, and erratic Chinese COVID-19 policies, with their impact on both supply chains and consumer demand. Those are just the known unknowns. Sprinkle in some unknown unknowns like the China-Taiwan impasse, and it’s clear that there just isn’t a simple road map to get us from 5 percent core inflation to 2 percent in 2023.
Peaking Rates
What we do know, at least for now, is that cash is king — short-term investments now pay higher rates than longer-term, high-quality bonds, and consequently many stock investors now dread recession risk. By summer you’ll be weary of hearing the arcane history of inverted yield curves. Whereas we began last year with many public treasurers foolishly investing their cash as long term as they could, trying to scrape up a few extra nickels in yield, the exact opposite is probably the dominant scenario for coming months as overnight rates become the shiny new objects. It’s a pretty safe bet that money market interest rates will peak at somewhere around 5 percent this year, barring a tumultuous Crazy Ivan move by Putin.
So what does all this portend for budgeting revenues and maximizing returns on public funds? Long-bond yields can drift lower, but only a little: The Fed still holds over $3 trillion of long-maturity Treasury bonds and mortgage-backed securities it bought during the pandemic, and will likely liquidate only a third of that this year, so there is still a massive long-bond supply overhanging this market. I struggle mentally to see less than 3 percent yields on the 10-year Treasury this year, which is only a half point below today’s levels.
By December, mortgage rates can soften to maybe the lower 5 percent range, which is helpful to local property values and that tax base, and muni bond yields can drift slightly lower in tandem with Treasury's. But the Fed’s quantitative tightening must continue all year in the long end, to flatten out the M2 money supply enough to make 2 percent inflation a viable target credible to monetary hawks. That won’t shrink the money supply, and given the risk of recession I don’t expect active open-market sales of its portfolio T-bonds by the Fed, but the runoff of maturing bonds must continue. That puts a floor under longer bond yields as new and replacement buyers at the weekly Treasury debt auctions must surface to buy the incessant supply of new U.S. bonds. In case you’ve forgotten, Capitol Hill is still running a $1 trillion annual budget deficit, which requires ever more debt issuance and somebody other than the Fed to buy that paper.
We’ll have to see how many of the underwater public treasury portfolio managers — those who last year proclaimed themselves to be driven by the benefits of “investing as long as possible under their cash forecast” — will continue to do so when yields are relatively lower on longer maturities. In 2022, they declared allegiance to their cover-up story of buy long and hold, come hell or high water, and they got both. Now we’ll get to see just how many were actually just grabbing the highest rates that brokers quoted them. Don’t be surprised if some continue to chase yields and that we start to see those elongated average portfolio maturity statistics shrink as this rate cycle peaks. Strategically, most cash managers will be bobbing like corks in the ocean this year, with no real sense of direction.
Budgeters’ Quandary
Another professional challenge with interest rates this year will be the budgeters’ quandary of how long these higher rates will persist into 2024 to fund ongoing operational costs. With interest income becoming an increasingly important sliver in state and local budgets, this is a non-trivial problem. Some financial teams may decide to take the plunge and lock in the best yields they can into the following fiscal year, even if it means a modest revenue haircut from the tempting short-term rates that prevail this spring, but that requires a team effort by the treasury and budget staff that doesn’t always prevail in the oft-compartmentalized world of state and local government financial functions.
For debt managers, this year should bring an eventual normalization of the muni bond market, as disinflation should enable tax-exempt yields to revert to historical relationships with the federal government bond market. With a partisan-divided Congress, there might be some trivial tinkering in federal tax laws for muni bonds, but don’t expect anything major. Eventually, sagacious muni investors may begin to focus on what will happen when the upper-bracket Trump-era tax cuts expire in 2025, and rediscover the beauty of tax-exempt paper, but only a few will actually think that far ahead of the next election. Said simply, it’s business as usual now.
Shorter term, the talk on the street is that muni bond maturities in early 2023 will outstrip new supply, adding to the demand for those bonds, so issuers face a favorable market tone even before interest rates overall begin to soften along with disinflation. Relatively happier times are here again, at least for some issuers, until June when foreseeable new supply will exceed maturities while competing taxable market yields likely trend a bit lower.
Strategic Planning, Anyone?
For months now, the debate among economists has been whether (a) we’re gliding into a soft landing, as the Fed steers the economy into a tepid lower-growth (or zero-growth) pace, or (b) if its creaky monetary brakes and oversteering will eventually drive a shrinking economy into a recession with a measurable, painful decline in total economic activity, job losses and higher unemployment. Nobody talks about what’s in between.
My outlook is that we face a year with weakening real GDP, bringing higher unemployment rates but not a full-blown recession. In the 1970s they called this “stagflation”; for now I call it a slog. Prudent budgeters should now avoid new fiscal commitments and keep dry powder just in case. This all makes for a good year for strategic planning, which can keep competing constituencies occupied with long-term economics instead of vying for short-term budget gimmes. It also sets the table for smarter multiyear labor deals, as discussed below.
At the local level, what is clear is that the unliked-but-reliable property tax has probably seen its best days in this cycle, as that revenue item is likely to fall short of the salary and pension-cost pressures that most governments will face by 2024. Whether that squeeze begins to impact their budgets in 2023 is situationally dependent and defies generalization. Property assessment practices vary widely, and often with a long lag. In some states, tax caps will bite.
If a full-fledged recession hits, then sales and income tax revenues will surely fall short of budget, but by how much? My view is that at worst we face a soft, sloggy recession in which the GDP stalls out; many companies will “trim the fat” and lay off some workers or freeze hiring to “right-size” their workforces. Notably, this scenario does not necessarily imply that state and local governments will endure heavy layoffs. More likely, we’d first see governmental hiring freezes, suspended animation in salary increases, rainy-day reserve drawdowns, and other short-term measures to keep public employees on the payroll and service levels sustained.
Labor negotiators will call this a year of “collective bickering.” Public employers might be wise to proffer two-tiered pay increases this year: a base-pay hike that can be sustained and tolerated over time, perhaps something less than 5 percent, along with a one-time stipend or a contingent, supplemental pay increase that can be canceled or reversed if the employer’s budget suffers serious damage from a shrinking economy. The second tier could be reinstated or triggered in the future when revenues solidify sufficiently to assure fiscal stability without layoffs.
Tempests in Pension Teapots
This economic scenario is not positive for public pension funds. They and their employer sponsors will eventually see some sticker shock when the results of recent inflation coupled with investment market-value losses have worked their way through the actuarial meat grinder. Five-year rolling investment average values in the stock and bond markets slumped last month vs. the prior year and may decline further this year, which bodes trouble for pension actuaries. But those resulting unfunded liabilities won’t hit payroll contribution rates until 2024 or beyond. It’s a good time for three-year budget planning by public employers and for pension cost-sharing with the unions (who reflexively ask for gain-sharing). Hopefully, stocks may recover beautifully in 2024-2025 and beyond, easing actuarial pressures after this period of belt-tightening and fat-trimming, but hope is not a strategy.
No matter what happens on pensions’ fiscal front, the funds will continue to be politicized. From left field, fund boards may again find themselves drawn back into the culture wars this year as activists prod public-fund trustees to join proxy fighters on the issue of social media companies’ corporate policies regarding hate speech and content moderation. From right field, there will be more noise about environmental-social-governance policies, with pushes to use red-state pension funds and muni bond underwriter blackballs as their weaponry against such exercises in “woke culture.”
Much of this is just symbolic statehouse political theater, but pension trustees in several states will face spirited debates about their fiduciary vs. civic responsibilities. Ultimately, though, none of these Kabuki antics by noisy actors seeking to use pension boards as megaphones will move the needle on actuarial calculations, payments to retirees or employer payroll contribution rates.
In the end, it's still too soon to imagine a world without COVID-19 variants and budget-pinching inflation, but the trend toward normality on both of those fronts looks hopeful. In this intervening year between the noisy midterms and the next big general election, this should be a quieter period best suited for domestic housekeeping, long-term planning and fiscal prudence.
Governing's opinion columns reflect the views of their authors and not necessarily those of Governing's editors or management.
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