States Respond to Inflationary Pressures

By Christina Gordley

Most indicators of the health of the U.S. economy have returned to pre-pandemic levels. Unemployment is at 3.6% and the employment payroll has returned to 151.7 million jobs. Consumer spending was $405.5 billion in the last quarter.

The economy is healthy, but these indicators point to what could be too much of a good thing. Demand for goods continues to outpace supply, which is creating a substantial increase in prices. The Consumer Price Index, the measure of price changes in a basket of goods and services, increased 8.6% over the past 12 months. Wages have not increased at the same rate, so people are experiencing a cost of living squeeze.

Federal Response to Rising Prices

The federal government has some levers to try to control escalating prices.

The Federal Reserve System is the combination of entities that try to maintain a sound financial system and promote employment and stable prices.

• The Board of Governors is responsible for overseeing the 12 regional Fed banks. The board is composed of seven members appointed by the president and confirmed by Congress.
• The Fed banks function as the “banks for the banks,” providing services like loans, payment processing and other support to help financial institutions conduct business with individuals, businesses and governments.
• The Federal Open Market Committee sets the target for the federal funds rate, which is the interest rate that financial institutions pay to the Fed banks for access to the resources necessary to respond to the financial needs of consumers.

A rule of thumb is that financial institutions will charge an interest rate to individual and business borrowers about three percentage points higher than the federal funds rate. When the federal funds rate is 1%, for example, banks charge around 4% to consumers. The Fed reduced the federal funds rate in March of 2020 from 1.75 to 0.25. This resulted in the interest rate to consumers falling from 4.75% to 3.25%. This was part of the Fed’s effort to spur consumer spending by making it cheap to borrow money.

The Fed is now adjusting the federal funds rate upward, trying to dampen consumer spending.  When the federal funds rate rises and it costs more for banks to secure assets, the interest rate for borrowers also increases. The intended result is a slowing of price increases as demand decreases. In June, the Fed ordered an increase in the rate to 1.75%. In addition, an increase in the lending rate makes it more attractive for consumers to save money because they get a better interest rate.

The Fed also influences how much in financial reserves that banks must maintain. For example, a bank has $100 million in deposits from customers. Instead of having to hold the $100 million and then use other assets for lending, a reserve rate might require the bank to keep 10% of the deposit amount on hand and can use the other $90 million for lending. In March of 2020, the Fed reduced the reserve rate to 0% to increase the cash banks had available to lend and decrease the cost of borrowing. The Fed can also increase the threshold for reserves, reducing the amount of money available for lending.

While many of the factors influencing inflation — supply chain issues and the war in Ukraine — are outside of the control of the federal government, the increased cost of borrowing money will hopefully ease price increases. Meanwhile, state governments are monitoring the impact of high prices on their citizens as the cost of living outpaces increases in wages.

State Responses to Rising Prices

State budgets are experiencing robust balances because of three rounds of federal investments to offset the impact of the COVID-19 pandemic and enable economic recovery. State budgets also benefit from the recent increases in employment and wages, strong consumer spending and rising prices. This is because most state governments rely on sales taxes, which reflect spending and the cost of goods and services. For example, states have unprecedented levels of savings in their rainy day funds, according to a recent report by the National Association of State Budget Officers.

States will be impacted in the near term in their own spending by increases in the cost of goods and services and the cost of borrowing. While the Fed can implement policies in an attempt to temper inflation, states have few options to combat prices because states operate in the midst of a national and global economy.

Policymakers may have several issues presented to them with few solutions available for a quick fix.

• Borrowing will cost more. State governments do not borrow funds from a bank like a private consumer. As a result, state budgets are not impacted by the federal funds rate and resulting interest rate increases in the same way as households. However, states do issue long-term bonds and short-term notes to private individuals and businesses to finance larger capital projects like roads, school buildings and technology infrastructure. The cost of borrowing for states will increase because they will have to offer higher paybacks to potential bond and note purchasers.
• Capital projects may cost more than originally anticipated because borrowing money is more expensive, wages for workers are up and supply chain issues will affect the availability of equipment, which may extend the timeline of projects.  
• Pension obligations, which are often sustained by investments of available funds in stocks, will be affected by the recent decline in the value of such assets during the current market downturn.
• Social services will be in greater demand as households continue to face rising prices from the fuel pump to the grocery store while wages are not rising as fast.

It is a delicate balance for states that are experiencing revenue surpluses while their residents are struggling to make ends meet. Policymakers have implemented or are considering actions to provide financial relief to their residents, such as sending direct cash payments or providing increased services.

However, inflation is a complex national equation and increasing the spending power of individuals can also contribute to the inflationary pressures by sustaining the heightened demand for goods and therefore prolonging higher prices.

• California is considering an $8 billion relief program funded from the budget surplus to provide a $200 cash rebate for each taxpayer and $200 per child.
• The Colorado Cashback program is providing a $400 dividend from the state surplus for direct relief to households.
• Georgia adjusted the income tax credit for 2020 and 2021 to redistribute some of the state’s budget surplus. Depending on the individual filing status, the amended individual income tax refund received ranged from $250 to $500.
• Hawaii will provide $300 to each taxpayer and dependent in households earning less than $100,000 and $100 to each taxpayer and dependent in households earning less than $200,000.
• Kansas eliminated the sales tax on grocery items.
• Maine recently approved a supplemental budget that uses half of the state budget surplus to provide $850 direct relief payments to individuals who filed a 2021 income tax return. Maine retirees — who are often on a fixed income — will receive an increased exemption from tax on their pension income. Maine has also increased the Earned Income Tax Credit to benefit an estimated 100,000 low- and middle-income working families.
• Michigan appropriated $4 million for the Food Security Council in the budget that begins in October 2022.
• Minnesota Gov. Tim Walz proposed a $500 rebate for each taxpayer.
• New Mexico sent $200 million in direct economic relief payments to households. Individual tax filers received $250 and joint filers received $500 payments in June, with a similar payment set for August. Additionally, New Mexico set aside $20 million for economic relief payments for households that did not file income tax returns due to their income levels.
• Pennsylvania Gov. Tom Wolf wants to utilize the American Rescue Plan funds to send $2,000 to each taxpayer.
• Utah enacted a property tax program that allows individuals over the age of 75 and with income below 65,000 to defer their property tax payments until there is a transfer of ownership. Utah policymakers also reduced cell phone bills by eliminating fees that were directed to public safety communications, appropriating general fund resources to support those services.