Special Briefing: The Debt Ceiling Deal and its Impact on the U.S. Economy, States, and Municipalities

Municipal Market Faces More Hurdles After Debt Ceiling Deal

• Biden's deal with McCarthy spared state, local governments from onerous cuts
• "Perilous, complicated, politically fraught" appropriations process looms
• Inflation, elevated interest rates seen persisting into 2024
• Investor base shrinks, as banks, insurers reduce muni footprints
• "The next fight ... will be about health care"

Though this month’s debt limit deal spared the municipal market from onerous cuts in federal fiscal support, panelists at a June 15 Special Briefing said state and local governments still face a risk of reduced federal spending while they also contend with inflation, high interest rates, reduced demand for their bonds, and a looming crisis in the health care sector.

The spending caps and clawbacks of COVID relief spending in the Fiscal Responsibility Act proved less disruptive to state revenue than some officials had feared, said Marcia Howard, executive director Federal Funds Information for States, at the webinar hosted by the Volcker Alliance and Penn Institute for Urban Research. But a “perilous, complicated, politically fraught” process lies ahead as some Republican lawmakers now say they want to set appropriations at fiscal 2022 levels, a substantial cut from the 2023 levels agreed to during debt negotiations.

Moderated by William Glasgall, Volcker Alliance senior director, public finance and Penn IUR fellow, and Susan Wachter, co-director of Penn IUR, the briefing was the forty-third in a series of sixty-minute online conversations featuring experts from the national research networks of the Volcker Alliance and Penn IUR, along with other leading academics, economists, and federal, state, and local leaders. In addition to Howard, the panel included: Matt Fabian, partner, Municipal Market Analytics; Annie Linskey, White House reporter, the Wall Street Journal; Vikram Rai, managing director and head of the municipal strategy group, Citigroup; and Torsten Slok, chief economist, Apollo Global Management.

“The debt ceiling deal was much smoother than many of us expected,” Linskey said, referring to the negotiations between House Speaker Kevin McCarthy and President Joe Biden that averted a default on United States debt. “Muscles were exercised that we did not really know existed.” The budget debate in the fall “is going to create another friction point,” she said, “with a little more room in the appropriations process for negotiations from the administration side.”

While state and local governments are currently flush with revenue from trillions of dollars in COVID-19 relief money, they face stiff economic headwinds. Slok said inflation remains elevated, at about 5 percent compared with the Federal Reserve target of 2 percent, and interest rates are likely to remain high well into 2024, raising borrowing costs for municipalities, consumers, and businesses. The consensus among economists calls for recession by next year that would reduce earnings and state tax revenue, he said. In addition, Slok said the lifting of the debt limit may lead to a glut of Treasury securities issuance, with negative implications for demand for municipal bonds.

Rai said banks and insurers are reducing their investment in municipal bonds. That means issuers “have to become more reliant on retail investors,” Rai said, “and they are more fickle.”

The return on municipal bonds has lagged behind that of other investments this year, he added. “For munis to become more attractive, they have to cheapen more, which does not bode well for state and local governments.”

Fabian said the crisis showed that it will be increasingly difficult for the federal government to downstream money to the states. “And when they downstream less money to states,” he said, “that means either the states pick up responsibility, or the states downstream those costs to locals or individuals’’ through taxes and fees.

Because the deal extended rather than eliminated the debt ceiling, “this drama is going play out again in 2025,” Rai said. “The next fight, unfortunately, is going to be about health care,” which accounts for about 25 percent of all federal spending. “We know the state of the health care system is eroding.”

“This year over $9 billion of hospital debt has disclosed some kind of technical default,” Fabian said. Not-for-profit hospitals are “absolutely a sector that investors are watching very closely.’’