Brad Keithley’s chart of the week: Adjusting for inflation

In anticipation of the upcoming Spring Revenue Forecast, last week’s column reviewed what current and 10-year revenues likely will look like when adjusted for the current oil futures market. This week we take a look at the spending side, adjusted for inflation.

There is no doubt that the outlook for inflation has changed significantly since the Dunleavy administration published its 10-year forecast of spending levels last December in its FY2023 Budget Overview and 10-Year Plan (10-Year Plan). As some readers may recall, even at that time we questioned the inflation rate used in the forecast.

To address those concerns, in our December effort to “adjust the Governor’s 10-year Plan for reality” we substituted for the rate used by the administration the then-current “10-Year Breakeven Inflation Rate” derived from U.S. Treasury bond markets. As described by the St. Louis Federal Reserve Bank (FED), which publishes the data on its “FRED” website, that rate “implies what market participants expect inflation to be in the next 10 years, on average.”

To some degree, the breakeven rate is the inflation corollary to the oil futures market. Both are forward looks based on what market participants actually investing money think the value of the product they are purchasing will be at a future point in time.

At the time we published our December piece, the 10-year breakeven rate was 2.5%. As we write this week’s column it is now in the range of 2.9%, 16% higher.

In addition to the 10-year breakeven rate, the St. Louis FED also publishes daily data for a 5-year breakeven rate. At the time we published our December piece, the 5-year breakeven rate was higher than the 10-year, though not significantly so. As we write this week’s column the 5-year rate is now in the range of 3.4%. The St. Louis FED also publishes data for a 7-year breakeven rate, although because it is reported monthly instead of daily it is not widely used as a benchmark.

While elevated from their December levels, both the 5-year and 10-year breakeven rates are significantly lower than current inflation levels as measured by either CPI-U, the most widely reported inflation rate, or core PCE, the Federal Reserve Board’s preferred measure.

Currently, those rates (annualized) are 7.9% (CPI-U) and 5.2% (core PCE). Some are proposing to adjust proposed spending levels based on those rates.

But using the current rates to forecast future rates embeds the same fallacy in future spending levels as using current Permanent Fund returns or current oil prices to forecast future earnings levels or prices. Like those, inflation rates don’t remain static. As the future-facing breakeven inflation rates show, market participants anticipate FED and other actions will lower future rates significantly.

In an effort to fully incorporate the breakeven rates in our analysis of the impact of inflation on projected spending levels, in this column we use the St. Louis FED’s 5-year breakeven rate for the first five years, then the lower rate for the last 5 years that results in the 10-year average (the so-called “5-year, 5-year Forward Inflation Expectation Rate”). As we write this week’s column, the resulting rate for the back end 5 years is in the range of 2.4%.

To calculate the impact of those rates on spending levels we use the updated (as of February 17) Fiscal Model published by the Department of Revenue, which for those interested in doing their own analysis is available on the front page of DOR’s website. Among other adjustments, this version of the model enables users to substitute percentage changes in spending levels by year (i.e., inflation) for the assumptions built into the OMB 10-Year Plan.

As readers may recall from our December discussion, that Plan basically incorporates 1.5% inflation into its numbers. In using the model we have substituted the inflation levels projected in the 5-year and 5-year, 5-year Forward Breakeven rates discussed above for the 1.5% inflation rate embedded in the OMB 10-Year Plan.

This is the result:

Between FY23 and FY30, accounting for current market estimates of inflation adds, on average, $500 million per year to the spending levels previously projected by the administration in the OMB 10-Year Plan. Understandably given the compounding effects of interest, the annual effects start out relatively small in the near term, cascading into larger effects in the intermediate and longer term.

What does that mean for the overall budget?

Not that much in the near term (next 3 years). Over that period, directionally the outcomes adjusted for inflation are much the same as under the various approaches we discussed in our column last week.

As the compounding effects of inflation add up, however, the outcomes change in the intermediate (middle 3 years) and longer term. (In doing the analysis below, we have held the revenue side constant between last week’s column and this in order to focus attention on the effects of inflation.)

As we discussed last week, while the proposed FY23 budget continues to balance – in fact, produces a surplus (red below the line) – at currently projected revenue levels even after paying a statutory PFD, it quickly flips to a deficit (red above the line) beyond that.

In last week’s column, Governor Mike Dunleavy’s (R – Alaska) approach – splitting the POMV draw equally between the PFD and government (“POMV 50/50”) – showed a surplus or, at a minimum, near balance throughout the remainder of the decade.

But layering on the impact of current inflation expectations changes that. While the approach continues to produce a surplus for four years, and near-ish balance for one more beyond that, after layering on the effects of inflation it flips to a deficit over the last three years covered by the 10-Year Plan even at the substantially higher prices currently prevailing in the oil futures market.

Analyzing the issue in terms of breakeven prices – what would the price of oil need to be to produce a balanced budget (i.e., break even) under the various approaches – leads to the same conclusions.

For FY23, the breakeven prices for both the statutory and POMV 50/50 approaches are below the price levels currently prevailing in the oil futures market. But beginning in FY24 the breakeven price for the statutory POMV – and beginning in FY27 the breakeven price for POMV 50/50 – exceeds the price levels currently prevailing in the oil futures market.

The net result of these looks leads us right back to the same conclusion we had at the time we originally looked at the Governor’s 10-Year Plan last December.

While the price levels currently prevailing in the oil futures market buys the administration and Legislature some time before they need to be implemented, layering on the effects of inflation demonstrates it continues to be “time to turn to developing additional revenues (or phrased more accurately, substitutes for even deeper PFD cuts) as the appropriate next step in achieving a sustainable, long-term budget.”

Of course, some in the Legislature will argue that’s exactly what they are doing in pushing HB 259 and SB 200, two measures which, as we discussed in last week’s column, restructure the PFD to reflect a 25 (to the PFD)/ 75 (to government) split in the POMV draw.

But as we explained last week, those proposals both overshoot the mark – taking more out of the Alaska private sector than needed to fund government, even after adjusting for higher inflation (the red below the line) – …

… as well as lock in permanently the revenue approach – PFD cuts – that has the single “largest adverse impact” on both 80% of Alaska families and the overall Alaska economy.

The distributional impact of both HB 259 and SB 200 compared to current law is this:

A great result for the Top 20%, for whom PFD cuts are the best (i.e., cheapest) way to support government, but a horrible – indeed, unconscionable – result for both middle and lower income (80% of) Alaska families, from whom PFD cuts take the most as a share of income of any of the alternatives, and the overall Alaska economy, on which PFD cuts have the “largest adverse impact” of any of the alternatives.

The bottom line. While higher crude prices are providing the administration and Legislature with some additional breathing room, factoring in the resulting anticipated inflation levels makes clear its only breathing room, not a “get out of (fiscal) jail free” card. There is still a looming need to develop an alternative source of more equitable, lower impact revenues. Neither HB 259 nor SB 200 provide that. The legislature is wasting time by continuing down that road.

Brad Keithley is the Managing Director of Alaskans for Sustainable Budgets, a project focused on developing and advocating for economically robust and durable state fiscal policies. You can follow the work of the project on its website, at @AK4SB on Twitter, on its Facebook page or by subscribing to its weekly podcast on Substack.

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