How The Federal Reserve’s Rate Hike Would Impact Local Government

September 4, 2015 – Brandon Camhi

Read on for a non-technical explanation of December’s interest rate hike, its likely impacts on local governments, and how governments can prepare.

All eyes were fixed on Washington in December as the Federal Reserve raised interest rates. No one except the twelve members of the Federal Open Market Committee — the Fed’s rate setting body — knows when rates will rise for a second time, but at least one thing is clear: rising interest rates will affect state and local government debt.

How does the Federal Reserve Work?

The Federal Reserve controls the economy’s interest rates by manipulating the federal funds rate — the interest rate at which banks lend money to each other overnight. This rate is a floor on all other interest rates, as no banks have an incentive to offer a lower rate when they can receive riskless overnight interest in the federal funds market. If market interest rates are like a pile of books held by the Federal Reserve, then the Federal Reserve lifts the entire pile by applying direct upward pressure on the lowest book. Municipal debt interest rates are included in this pile of books.

As the economy heats up, the Federal Reserve hikes interest rates to prevent inflation and overspending. However, when the economy slows down, the Federal Reserve lowers interest rates to spur investment and lending. Since the 2008 recession, the federal funds rate has hovered between 0 and 0.25%, and the Federal Reserve already lowered rates before the 2008 crash. The recent interest rate increase was the first in nearly a decade.

Effects on Borrowing Costs

Credit ratings. Budgetary performance and outlook. Insurance. These factors — among countless others — impact state and local governments’ borrowing costs. However, like a football game, where individual players’ actions operate within the context of broader rules, these other factors operate within the context of overall interest rate trends. Municipal bond interest rates do not always move with the Federal Funds rate due to these other factors, but the rates tend to move broadly in the same direction due to the “pile of books” mechanism described above.

Most municipal debt is typically long-term, so an increase in the Federal Funds rate won’t have a large effect on borrowing costs for debt that is already issued, ceteris paribus. However, local governments that expect a rate hike in the near future may choose to refinance their debt at lower interest rates or retire their debt before rates rise. This often decreases interest costs. Annual data from 1978 to 2012 indicate that changes in interest expense per capita and changes in the federal funds rate are negatively correlated.

Source: Tax Policy Center, Federal Reserve Board

Effects on New Municipal Bond Issuances

Increases in market interest rates, however, do impact new debt issuances. Governments that issue debt during a rate hike must pay higher interest to attract buyers. Higher costs lead to fewer issuances, and the graph below reflects this trend. It compares changes in long-term debt issuances to changes in the Federal Funds rate and the inverse relationship is striking.

Note: The data are annual averages, since the debt data were only available on an annual basis.  Source: Federal Reserve Board, Tax Policy Center

We fit this relationship to a simple linear model and found that a 1% increase in the Federal Funds rate leads to a $28 decrease in long-term debt issued per capita. However, this prediction likely overstates the decline in new debt issuance that will occur due to the impending rate hike, all else equal. Rates are expected to remain low for a long period of time, potentially limiting the decline in new issuances. In addition, projects that were stalled during the recession may be re-launched as the general economic climate improves. These forces may be enough to counteract higher rates.

Preparing for the Interest Rate Hike

Decision makers will want to know how the recent interest rate hike will impact their governments in a wide range of ways. To answer this question, public administrators should generate detailed debt service reports to analyze their debt obligations and present information to Council. OpenGov’s reporting capabilities can help with this, delivering compelling insights into debt obligations. For example, one city’s Finance Department uses OpenGov to run an internal debt service report that examines issuance maturity and allows users to drill into interest obligations. The image below illustrates when each debt issuance will mature:

Any staff member in the city has the option to click on an issuance and drill down by interest rate, bond type, etc. For example, a staff member can click on the 2006 series and view interest rates on the 2006 series by maturity date:

Reports such as these make it easier for financial analysts to analyze their debt obligations to tell decision makers a story and decide what, if any, recommendations to make to Council. For example, cities may wish to refinance some long-term debt before the Federal Reserve raises rates. In seconds, OpenGov can tell analysts what a city’s interest obligations will be five years from now to determine whether the costs associated with refinancing are worth the benefits of lower rates.

Higher credit ratings will become more important in a period of rising rates, and OpenGov can help. For example, Standard and Poor’s gave the city of Simi Valley a AAA bond rating in part because the city deployed OpenGov’s Transparency Portal. Assistant City Manager Purtee elaborates on OpenGov’s role:

“I believe OpenGov was a factor in helping us achieve the historic AAA rating because of our commitment to transparency. One of the things we pointed out to S&P was that we made our budget information open to the public. Only a city with strong financial management would be willing to put everything out there online to allow people to really delve into the budgets. I believe S&P recognized this. That’s where I felt OpenGov played a part in the whole rating discussion and helped us in our overall score.”

Local governments with higher credit ratings can induce underwriters to offer their debt to investors at a lower rate than organizations with lower credit ratings, an important advantage in an economic environment where all interest rates are rising. The chart below indicates the higher interest rates that municipalities with lower bond ratings face; it is clear that the interest savings from a higher rating are significant, especially when compounded over time:

Source: WM Financial Strategies

Ultimately, local governments retain significant control over their own financial futures. They adopt financial processes and programs that dictate spending and credit ratings, they determine when and how to package debt after the voters have approved an issuance and they influence tax policy. Macroeconomic factors, however, affect all governments’ finances — ensuring that local governments do not operate in a vacuum. The Federal Reserve’s recent interest rate increase will impact local governments, and OpenGov’s operational reporting tools can help tell decision makers a story about these effects.

Category: Government Finance