Stimulus Update: Are Stimulus Payments Now Feeding Inflation?

Sometimes good news and bad news are thrown into the same basket.

Do you remember the early days of the pandemic when everything first shut down? Businesses shuttered, more of us worked from home, and there were legitimate fears regarding what would happen as tax revenue dried up and state and local governments could not pay for essential services. The federal government sent stimulus funds to those state and local governments to combat the problem.

The result? Municipalities are flush with money. They either use it to fund projects or share it with their constituents. In either case, it caused a snag, making it tougher for the Federal Reserve to tame inflation.

Between a rock and a hard place

In 2020, the federal government was in an impossible position. Either it sent stimulus funds to keep the economy afloat or watched the economy and 334 million Americans sink. It wasn't difficult to predict that extra money in bank accounts would lead to increased spending. In fact, that was the goal.

However, economists know that increased spending leads to inflation as people are more willing to overpay for what they want and need.

Still, the government faced an unwinnable situation. Any decision made would have both an up and a downside. It's that downside with which the Federal Reserve now grapples.

Avoiding a worst-case scenario

Bloomberg opinion columnist Karl W. Smith was previously vice president for federal policy at the Tax Foundation and an assistant professor of economics at the University of North Carolina. Smith explains that state and local governments were historically forced to cut spending when economic growth slowed and tax collections fell short. Those spending cuts led to a weakening of the overall economy.

Over the years, state and local governments got smart. Like every American family, they realized they needed an emergency fund to carry them through when money was tight. For example, leading up to the 2008 recession, states had an average of 17 days' worth of operating costs on hand.

A vast rainy-day fund

Fast forward to today, and the federal government's efforts to stave off economic disaster by providing states with funds. This influx of money means that by the end of 2022, the average state had an estimated 42 days of operating costs. That's a whole lot more money than they're accustomed to. To put this into perspective, Pew Charitable Trust's Fiscal Health Project says that states were sitting on $135.5 billion late last year.

With all that cash, Smith says that a typical state can weather a roughly 12% drop in revenue over the next year and still not be forced to cut spending. Back in 2008, states could only afford a 5% drop in revenue before they had to slash spending.

Money on top of money

What no one expected when the pandemic hit was that local and state governments would experience a surge in cash. Between increased tax revenue due to consumer spending and the hundreds of billions of dollars in COVID relief, it must have felt like it was raining money.

There's also the fact that employment in government offices has not increased as quickly as in the private sector. Smith points out that the private sector has expanded by 6% since August 2021, while state and local governments have grown by 2.3%. Government offices have not replaced the positions they once paid, so they have even more money available.

Good news and bad news -- simultaneously

Due to the rosy financial situation state and local governments find themselves in and the fact that consumer spending does not appear to be slowing, Smith believes the U.S. will avoid a recession, coming in for a "soft landing" instead. That's the good news.

The bad news is that the Federal Reserve may have to double down on its efforts to cool inflation by raising interest rates, and in this case, doubling down means raising the rates higher than any of us expected and allowing them to remain there until spending is under control.