You’re probably shelling out more for groceries, gas and even your heating bill these days. But while rising inflation has reduced some consumers’ buying power, it has different implications for state and local governments—some of them positive. This week’s newsletter touches on a few of those ripple effects.

But first, a little reminder that today (Dec. 15 @ Noon ET) I’ll be joining former Philadelphia Mayor Mike Nutter and former Kansas City, Missouri, Mayor Mark Funkhouser for a discussion on the outlook for local governments in 2022. If you want to hear about challenges, priorities and how the infrastructure bill spending all fits in, please tune in!

Register here

OK, on to the news.

All eyes on the Fed

The annual rate of inflation is growing at the fastest pace since 1982, driven mainly by rising prices for food and energy. Rising prices don’t immediately change government spending and revenue projections, but the Federal Reserve—which wraps up its quarterly meeting today—does have an influence.

The Fed manages increasing inflation two ways: by hiking short-term interest rates and cutting back on its bond-buying program (quantitative easing). It’s already slowed the latter and experts predict the Fed to now hike short-term interest rates earlier than expected—perhaps as soon as June, one CNBC survey found.

Quantitative easing: In recessionary periods, the Fed stokes the economy by buying long-term bonds from banks to free up money for them to make more loans to people or businesses. When the economy recovers and inflation rises, it usually sells those assets. This reduces money in the economy, which should reduce inflation.

The big picture: Higher interest rates will make it more expensive for you and I to borrow money. But for governments borrowing in the municipal market, rising interest rates would likely only increase the cost of issuing short-term debt. That’s because a Fed’s rate hike only applies to short-term interest rates, not long-term ones.

And here’s a doozy: Sometimes a rate hike can actually cause long-term rates to move down. Between 2004 and 2006, the Fed raised the short-term rate from 1% to 5.25%. During that time period, the rates on a 10-year Treasury bond only went up a half percentage point. And yields on the 30-year bonds actually went down slightly. The reason is because when short-term interest rates are increased, it actually dampens the impact of inflation, which is what plays the larger role in setting long-term interest rates.

Inflation is good for public pensions

If inflation pushes up interest rates and accelerates wage growth, that could take some of the pressure off of public pension plan performance. Since the Great Recession, pension plans have been steadily lowering their assumed annual rate of return to better match the low-interest rate environment. Pension plan actuaries factor that rate when in calculating a government’s annual pension bill. Lowering that rate results in a higher bill because governments have to make up the difference.

More stable returns. Rising inflation can result in higher returns from a pension plan’s fixed-income assets. Unlike the volatile equities market, the nice steady investment return from fixed-income securities is much nicer to rely on from a planning perspective. In fact, bonds used to be pensions’ bread and butter until interest rates began falling in the 1990s.

The National Association of State Retirement Administrators’ research director Keith Brainard told me this week that if inflation is sustained, governments could decide to stop lowering their investment return assumptions and some could even start raising them again.

That could result in lower pension bills for governments with healthy plans. Or in the case of struggling plans like Chicago or Kentucky, it could at least slow the pace of their rising pension bills.

Higher worker contributions. What’s more, noted Brainard, accelerated wage growth also means those workers paying into pension plans will be contributing slightly more. “What wages will do when inflation is 2% is a lot different than when it’s 6%,” he said.

Dig in: As Retirees Outnumber Employees, Pensions Seek Saviors

Putting American Rescue Plan money to work. (In the bank.)

Normally when governments get a grant from the federal government, they put it into a bank account and withdraw the funds over a period of time. But any interest the grant money accrues while in the account has to be returned to the feds.

The Treasury Department made an exception to this rule for Fiscal Relief Funds coming from the American Rescue Plan—governments can keep the interest. Keep in mind also that governments have until Dec. 31, 2026 to get that money out the door (though they do have to obligate it by the end of 2024). Moreover, the rule says that interest earned “is not subject to program restrictions,” meaning governments can use that money however they see fit.

Government treasurers and comptrollers can be strategic about the type of account they’re placing their ARP funds in and use a potential uptick in short-term rates to maximize their grant money. This ultimately may not mean much to smaller governments receiving a few million dollars. But it can add up for large governments receiving hundreds of millions of dollars that aren’t all being spent it right away. Even just a 2% interest payout on $10 million is $200,000. That’s a few park benches, money for an employee appreciation day or new grant money to award to a local nonprofit.

What I’m watching

Data, evidence and ARP spending. Large governments are required to report on their use of data and evidence, as well as outcomes from their American Rescue Plan spending. Results for America recently released a first-of-its kind dashboard that uses city performance reports to track how cities are using their funds. Equity and data also feature prominently in the infrastructure bill, so how cities are approaching equitably spending ARP funds could be a preview of what’s to come.

Digital government. The latest survey of chief information officers highlighted expanded cloud services, digital government services and increased use of data analytics among their top investment practices that are here to stay, post-pandemic. Automation will be crucial for governments as they adapt to a future with fewer workers and more on-demand expectations from their constituents.

That’s it for this week and if you’ve made it this far, I’d love your feedback. Was this too long? Too short? What did you like and what could you have done without? Please don’t hesitate to reply to this message with your thoughts.

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Long Story Short

Three subtle ways inflation helps state and…