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Tue, Jul 13, 2010 - Page 10 News List

New worries for US Fed — state and local finances

REUTERS , WASHINGTON

The US Federal Reserve’s list of worries may be getting longer.

A fading recovery, persistently high unemployment, Europe’s debt troubles and commercial real estate losses have garnered most of the attention. However, some Fed officials have begun talking more about another trouble zone — recession-hit US state and local government finances.

The problem is that they have to balance their budgets, unlike the federal government, which is running a deficit equal to more than 10 percent of total economic output.

“They have no choice but to cut spending or raise taxes — or they get some more help from Washington,” said Harm Bandholz, an economist with Unicredit.

He thinks state and local government finances represent the most important domestic risk factor in the US economy. Yet they received only two brief mentions in 19 pages of minutes from the Fed’s April policy-setting meeting.

Minutes from the Fed’s last meeting, on June 22 and June 23, set for release tomorrow, are likely to show the central bank trimmed its economic growth forecast, largely because of a run of disappointing data and fears of a European slowdown.

Bandholz said the Fed might be reluctant to say much more about state and local government budgets because that would involve treading into the realm of fiscal policy, which is the US Department of the Treasury’s responsibility.

However, they may draw more attention as the problem gets worse. Next year’s state and local government budget gap is expected to reach US$140 billion, or a little more than 1 percent of GDP. Considering economists expect GDP growth of only about 3 percent next year, that is a substantial hit.

In the first quarter of this year, state and local governments ­subtracted 0.5 percentage points from GDP. That was equal to the reduction from commercial real estate, a primary area of concern for the Fed.

Economists are predicting weak retail sales for last month and a small decline in industrial output.

Government budget cuts weigh on economic growth because they can lead to job losses and spending reductions, as well as higher taxes that constrain consumer and business spending. In the first quarter, state and local governments reduced spending at a 3.9 percent rate, the steepest drop since 1981.

“This situation is our nation’s very immediate analog of the public finance pressures being felt in Europe,” Dennis Lockhart, president of the Atlanta Fed, said in a June 30 speech, one of a smattering of recent Fed references to state and local government budgets.

It is likely to become a bigger drag over the next 18 months. As part of last year’s US$863 billion stimulus package, the federal government gave money to help close state and local budget gaps. However, the transfer payments peaked in the second quarter of last year and are running out.

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