Fed’s recent rate cuts could improve borrowing options for state and local government projects

The Federal Reserve's second consecutive key rate cut could mean more than just lower borrowing costs for the average consumer — state and local governments stand to benefit, too.

Lower interest rates may bring changes for housing development, tax revenue, debt refinancing and bread-and-butter projects like roads, water and sewer, state and local government officials told States Newsroom.

The Fed's cut earlier this month followed an aggressive rate-hiking campaign to beat down inflation, and it came years after the last time the U.S. central bank lowered interest rates. Key borrowing rates now stand at 4.5-4.75%, and inflation has cooled to 2.7%. Economists expect another rate cut in December.

"On average, the lower the interest rates are expected to help stock market returns if historical trends hold," said Liz Farmer, who focuses on budgets, fiscal distress, tax policy and pensions at The Pew Charitable Trusts. "So generally, you would expect a more positive effect on your average pension portfolio that has a good amount invested in equities."

This change means states and localities will have lower borrowing costs, which will make it easier to make big long-term changes in infrastructure, to see higher sales tax collections as a result of more spending, and it is likely to result in better pension performance in an environment where stocks tend to respond to lower rates, fiscal policy experts at Pew say.

In 2021 and 2022, states had record high revenue growth due in part to federal pandemic aid and the impact of the federal aid on workers and businesses, according to Pew. But that kind of growth was unsustainable.

Recently, nearly all states have entered into a slower revenue growth environment, said Brian Sigritz, director of state fiscal studies at the National Association of State Budget Officers, a professional membership group for budget and finance officers. More than three dozen states had a fall in revenue in fiscal year 2023, Pew's analysis found. At least five states experienced budget shortfalls in fiscal year 2024, the think tank explained.

"States overall are remaining in a strong fiscal position. It's just that we're starting to see slower growth compared to what we did see for those a couple of years after the start of the pandemic," he said. "That was really a unique set of circumstances where we had the additional federal aid provided by all the different Covid relief bills and at the same time where state revenue growth was growing so strongly, and that led to very strong growth in tax collections."

Sigritz said that states, which have to almost entirely use borrowing for infrastructure and capital projects, will benefit from lower borrowing costs as a result of the Fed rate cuts.

David Schmiedicke, finance director for the city of Madison, Wisconsin's finance department, said he's hopeful that the lower cost of borrowing will reduce the cost of public infrastructure when seeking construction bids.

"We're seeing a lot of development, even with the higher rates. Madison is an attractive place to live. People from around the country are moving here," he said.

Rebecca Fleury, the city manager for Battle Creek, Michigan, said interest rates affect key services the public relies on, including fire departments.

"[Interest rates] have an impact on our ability as a city of 52,000 to provide the full services that we do. Every little bit impacts us, because we have to buy fire trucks," she said."If there's a decrease in one of our three largest revenue sources, we feel it."

But there are both pluses and minuses to the cut in the federal funds rate, Schmiedicke said, as it brings down the interest income states receive.

"It probably will reduce the amount of investment income the city receives on its cash balances. We saw that go up dramatically in 2022 and 2023, so that'll probably come down as the Fed cuts rates," Schmiedicke said.

Different tax policies also change how states and localities experience the Fed rate cuts.

H.D. Palmer, deputy director for external affairs and principal spokesman on fiscal and financial issues for California Gov. Gavin Newsom, said that the lower interest rates are overall positive for the nation's largest state because of the concentration of technology firms there, its progressive tax rate, and the taxing of capital gains and stock options as personal income.

"When the markets are doing well, those types of firms that are concentrated in California do well and in consequence, our revenues do well," Palmer said.

The Alabama Department of Finance told States Newsroom that it is closely following the Fed's actions as it "closely follows all actions that could impact our citizens and the State's revenues."

But the state agency said it may take some time to see any of the effects of recent rate cuts.

"While recent changes in the federal funds rate may lead to increased state revenues, absent a significant change in the rate, the impact on revenues and expenditures would not likely be seen immediately. We will continue to monitor and assess all economic indicators to ensure steady, sustainable, conservative growth for the benefit of all Alabamians," the department said in a statement.

Schmiedicke said Wisconsin is very reliant on property taxes because although state law allows a statewide sales tax and counties can impose a 0.5% sales tax, cities other than Milwaukee have not been able to do so. The state also has strict limits on property tax increases.

"We could see more development in the city and that could definitely help with our overall property tax base, as well as if it results in more travel and room taxes," he said.

As states and localities wrestle with how to provide more affordable housing, with nearly half of renters having to spend more than 30% of their income on housing, lower interest rates could help spur more building. Fleury said the costs of loans and labor and materials has been "astronomical," making it hard for developers to build. Although she said Battle Creek would love to take advantage of Low Income Housing Tax Credits, it's challenging to fund projects.

"I think that a lower interest rate could really help us get farther along in our housing plans," she said "If you can't get your project to pencil within what they're able to fund or finance, we just never make the list."

Despite lower interest rates creating a better environment for affordable rent and homes, states will likely continue to spend a lot of energy on housing programs, Sigritz said. Governors' budget proposals and state of the state speeches have prioritized affordable housing more and more in the past few years, he said, and he expects this to continue.

"Housing affordability is not an issue that's going to go away overnight, and there's still a need for more housing," Sigritz said. "It takes a while to build additional housing even in the lower-interest environment."