What the Federal Reserve’s policy shift means for state and local budgets

The Federal Reserve intended for Wednesday's interest rate cut of 0.5 percentage points to stimulate the broader economy, but this shift in monetary policy also represents a subtle but important change in the operating environment for state budgets. Interest rates affect every aspect of government finance, from revenue to infrastructure projects, and although the effects on state and local budgets will be gradual, the first rate cut in four years sends a message.

"This decision reflects our growing confidence that, with an appropriate recalibration of our policy stance, strength in the labor market can be maintained," Federal Reserve Chair Jerome Powell said at a press conference after announcing the cut. He also cautioned that the Fed is "not on any preset course – we will continue to make our decisions meeting by meeting."

One of the most immediate impacts of lower rates will be lower borrowing costs for state and local governments seeking to finance critical projects, particularly infrastructure, and make other long-term investments. The higher interest rates of recent years have discouraged borrowing and, as Utah Legislative Fiscal Analyst Jonathan Ball noted during an interview with The Pew Charitable Trusts, this has led some lawmakers to tap historically large general fund and other cash balances to pay for capital projects.

With lower rates and declining balances, that could change. One rate cut won't necessarily spur more borrowing right away, but policymakers and other stakeholders are watching.

"It's more an indicator of what's to come," Ball said. "But if we keep going down this path and we get back to 2 percent on the federal funds rate – or below that – then we start to see debt costs that are super enticing."

In addition to making new borrowing more affordable, lower rates could prompt states to refinance older, higher-interest bonds to free up fiscal bandwidth for other priorities.

Lower borrowing costs also affect the housing market. As mortgage rates decline, buying and building homes becomes more affordable, which can have significant effects on state budgets – particularly by reducing demand for state-funded housing assistance. For instance, many states have implemented programs aimed at making housing more accessible and affordable for residents. But if lower interest rates help spur more homebuilding, that could lead to increased housing affordability and decreased reliance on these programs, potentially freeing up state resources for other pressing needs, such as education, health care, or infrastructure.

Beyond borrowing

More broadly, rate cuts could boost economic activity amid slower overall growth, and state and local governments could see an uptick in tax revenue as a result. More affordable borrowing often leads to increased consumer spending and business investments, which in turn yield higher sales and corporate tax collections.

"Maybe that's the biggest positive effect is if people in general are encouraged to take risks and feel secure in doing so because interest rates are a little bit lower," said Municipal Market Analytics analyst Matt Fabian in an interview with Pew. "That could be, overall, a good thing for the states."

This potential boost in tax revenue could help offset some of the declining revenue pressures that states are facing, including slowing economic growth and the fading of temporary factors – such as one-time federal pandemic aid to businesses and individuals and a shift in consumer spending from often untaxed services to taxable goods – that led to higher-than-expected tax collections in recent years.

In addition, the stock market, which typically performs well in lower-rate environments, could contribute to a revenue boost through higher personal income tax collections in states that tax capital gains and by bolstering pension fund investments. Because public pension systems tend to rely more on equities than other asset classes, stronger market conditions could enhance returns and help narrow the gap between pension assets and liabilities.

However, lower interest rates can also come with trade-offs, particularly for states with large budget reserves. Over the past decade, most states have built up record-high rainy day funds and other reserves, many of which generate interest income that provides a steady revenue stream to support state budgets. Amy Carlson, Montana's legislative fiscal analyst, noted that her state's general fund interest earnings topped $160 million this year – a dramatic rise from roughly $5 million a year when rates were near zero during the pandemic, adding: "That's where really the biggest windfall has been for us."

But as interest rates decline, so too will that income. Montana is using its earnings to pay off debt and other long-term liabilities, but for any states that might have used this income – and assumed it would continue – to help balance budgets or fund fiscal commitments, the rate cut would create new challenges.

Final thoughts

As the Federal Reserve begins reducing interest rates, state and local governments could benefit over the next several years. Lower borrowing costs and potential tax revenue boosts from increased economic activity and stronger stock market performance present positive opportunities for state and local finances. Additionally, greater housing affordability could reduce the demand for state-funded housing programs, freeing up resources for other priorities.

And although the reduction in interest income from rainy day funds and budget reserves could pose a challenge, the broader fiscal advantages of a lower-interest-rate environment are likely to outweigh those concerns. By proactively adapting their strategies, state and local leaders can maximize these benefits and continue to support their communities effectively in the evolving economic landscape.