Reading the Economic Tea Leaves: When and How to Prepare for an Eventual Downturn

Over the past few months we’ve been getting more questions through our Ask MRSC Inquiry Service about our opinion on the economy. The economy has generally been very strong across the nation and the state for several years now. That’s leading some to wonder if they should begin preparing for the inevitable economic downturn soon.

Economist John Kenneth Galbraith once said there are two types of economic forecasters: "Those who don't know and those who don't know they don't know." We are in the first category. While we can’t predict the future, we can pull together insights on this subject from a variety of sources to help you try to understand when and how best to prepare for a slowing economy.

The National Economy

The current economic cycle is approaching 10 years old by some measures. That is a long time by economic cycle standards, as historically, expansions tend to last around five years or so. This alone has led some to speculate that the “maturing” economic cycle has to change course soon. Some of the reasons for the expansion to last as long and be as strong as it has result from an aggressive economic policy. Changes in the US tax laws in late 2017 resulted in significant decreases in the corporate tax rate. In addition, the Federal Reserve (The Fed) has maintained a very low federal funds rate during much of this economic expansion and has been able to do so due to an extended period of low inflation. These actions, along with robust government spending, have kept the economy expanding for an extended period.

However, various news sources are reporting that the effect of the tax policy change are beginning to fade. In addition, The Fed has begun to raise interest rates. The first hike, from .0% to .25%, happened in December 2015. The rate first became zero in December of 2008, which means that The Fed has kept an aggressive monetary policy (essentially it was free for banks to borrow money) for seven years! The rate is currently 2.5% and is expected to be increased twice over the next year, likely in .25% increments.

The Fed has also begun selling assets acquired when it stepped in to help resolve the financial crisis during the Great Recession (2008-2009). This injected cash into the monetary system and helped stabilize the financial markets—though some debate about all of this continues to this day. As a result, The Fed expanded its balance sheet in an unusual way. They’ve maintained these assets for many years and began taking advantage of the strong economy by selling some of these securities, starting in late 2017.

Rising interest rates, the fading effect of tax policy changes, and normal market cycles are all adding up to suggest this economy may have peaked. However, national forecasts continue to show growth—though at a smaller pace—into future years. In reviewing several sources, the averages tend to call for a slowing Gross Domestic Product (GDP) from the 3+% growth in 2018 to just under 2% by 2021. Of course, economists like to point out the “headwinds” (negative factors that could cause lower results): and there are several currently. These include national politics (such as the trade disputes and conflicting signals—and actions—from national policymakers), geopolitical issues (such as uncertainty around North Korea and Middle-East conflicts, and a slowing of China’s economy) and the real effect of the increasing interest rates as described above.

Washington State

Meanwhile, here in Washington we’ve seen the expansion of the state’s economy over this same 10-year period. Washington State benefited from having key industries leading the way in the economic growth—namely construction, aerospace, and software. Consequently, employment grew at a faster pace in Washington than it did nationally. Per-capita income also grew during this same time. All this adds to a robust sales-tax-based economy.

The most recent report from the Washington State Economic and Forecast Council indicates a slowing but still growing economy (see image below). Remember, to have a recession we’d expect to see two consecutive quarters of declining economic growth (GDP), and no one is forecasting such a scenario anytime soon. More likely, we are in what is known as a “contraction” period. This is when growth in the economy begins to slow but isn’t negative. It’s common for the stock market to react to this slowing with sell-offs from the high levels developed during expansion, and we’ve begun to see that occur.

All that said, inflation has begun to increase, likely in response to a tighter economy as well as increases in the Federal Funds Rate. For most local governments, revenue increases struggle to keep pace with increasing costs (largely due to inflationary pressures). This is especially true when we begin to see concerns about the future economy, contraction in the numbers, and sell-offs in the stock market. Consumer confidence begins to dim, and our sales-tax-driven economy begins to show the effects. So, even if the economy avoids a recession you may still find it difficult to make your anticipated revenues cover the same levels of service to your community.

How to Prepare

The best way to prepare for an eventual downturn, and for a slowing economy as well, is to use this time to evaluate your entity’s resiliency.

Make sure you’ve adopted or recently updated your financial policies on fund balance reserves. Compare your policies to the advice provided in our Financial Policies Tool Kit. Setting aside resources never seems easy, but it will make it much easier to fill the gaps presented in future years when resources are growing at a much slower pace than they have been.

Consider adding an “economic stabilization reserve” to your fund balance policy. Many public services are needed most when the job market tightens. A common practice is to set a minimum fund balance policy and then an additional layer above that for economic stabilization. For example, the City of Redmond has had an 8.5% minimum fund balance policy for a very long time. This amount can’t be used without council authorization and is anticipated to only be used in a true emergency (e.g. natural disaster). In anticipation of economic downturns, the Redmond City Council also set a 4% economic stabilization reserve to help stabilize city services during these times. Redmond was able to use some of this reserve during the Great Recession to maintain a minimum level of service in the building permits and inspection service areas when permit revenues declined dramatically. Once the economy recovered, the city restored the reserve to target levels.

In conclusion, we do not see predictions of economic decline that would lead us to conclude that a true recession is in the near-term picture. However, there are those headwinds that economists worry about and the economy is clearly slowing down.

Now that your 2019 budgets are adopted, this is a good opportunity to check in on those fund balances, update your policies, and work to make your financial future more resilient. In addition to the resources on the MRSC website, the Government Finance Officers Association has a variety of fiscal resiliency tools available as well.

Questions? Comments?

If you have comments about this blog post, please comment below or email me at mbailey@mrsc.org. If you have questions about this or other local government issues, please use our Ask MRSC form or call us at (206) 625-1300 or (800) 933-6772.