Bernanke Says Stronger Recovery Would Help States Narrow Budget Shortfalls

Federal Reserve Chairman Ben S. Bernanke said an improvement in state and local government finances will depend on the rate of U.S. economic expansion.

“If the economy continues to strengthen at about the pace projected by the Federal Reserve and many private forecasters, states and localities may start to get a little breathing space,” Bernanke said yesterday in a speech in New York. Measures of risk in the market for state and local debt that rose earlier this year are now receding, he said.

Concern that a wave of cash-strapped local governments will default prompted investors to pull money from municipal bond mutual funds during the past 15 weeks. Spending cuts by state and local governments also contributed to a revision lower of U.S. gross domestic product growth in the fourth quarter.

“Continued evidence that states and localities are addressing fiscal shortfalls should help calm the municipal bond market,” Bernanke said in the text of remarks at the Citizens Budget Commission’s annual awards dinner in New York. “The Federal Reserve will continue to monitor the municipal bond market closely.”

Yields on top-rated tax-exempt municipal bonds maturing in 10 years fell about 35 basis points in February, the steepest monthly decline since August, according to a Bloomberg Valuation index. A basis point is 0.01 percentage point.

While measures of risk “remain elevated, they have been looking somewhat better recently, presumably reflecting expectations of continuing improvement in the finances of states and localities,” Bernanke said in the speech. The municipal bond market in general “seems to be functioning reasonably well,” he said.

Perceptions of Risk

States and municipalities can help reduce investor perceptions of risk in the market for their debt by closing budget gaps, Bernanke said.

Investors withdrew about $610 million from U.S. municipal- bond mutual funds last week, the least in 11 weeks, Lipper US Fund Flows said Feb. 24.

Speculation about the possibility of widespread municipal bond defaults intensified after Meredith Whitney, the banking analyst who drew attention for correctly predicting Citigroup Inc.’s 2008 dividend cut, said in December that “hundreds of billions” of dollars in municipal bonds may default this year.

Whitney’s analysis drew criticism from investors and state officials, including California Treasurer Bill Lockyer, who said her estimates were too high.

More Defaults

Roubini Global Economics LLC, the consulting firm co- founded by Nouriel Roubini, said in a Feb. 28 report that U.S. municipal bond investors can expect about $100 billion of defaults over the next five years.

“Because the pace of near-term economic growth expected by most forecasters is relatively modest given the depth of the downturn, some time will likely be required before state and local fiscal conditions return to something approximating normal,” Bernanke said in the speech.

Bernanke’s speech expanded on remarks in congressional testimony this week. He said on March 1 that while it’s “possible” U.S. states could pose a risk to the financial system, the Fed won’t purchase state debt.

“While states are facing very tough financial conditions, at least as long as the recovery continues, they are seeing higher tax revenues and that will at least be helpful to some of them,” he said March 1 in response to questioning before the Senate Banking Committee. “Obviously, this is something we have to watch carefully.”

Tax Receipts

California, Texas, New York and Florida -- the four most- populous U.S. states -- reported better-than-expected tax and fee receipts last month. That may foreshadow a fifth straight quarterly gain after 41 states said revenue in the last three months of 2010 rose 6.9 percent from a year earlier, the Nelson A. Rockefeller Institute of Government said Feb. 1.

Local tax revenues have held up “relatively well” compared with states in the past couple of years, Bernanke said. “The continued softness in real estate prices, however, does not bode well for local government revenues” because of the greater reliance on property taxes.

The economy grew at a 2.8 percent annual pace in the fourth quarter, down from a 3.2 percent initial estimate, as state and local expenditures fell at a 2.4 percent annual rate, the Commerce Department said Feb. 25.

“What we’d like to see is a sustainable recovery,” Bernanke said yesterday before Congress. “We don’t want to see the economy falling back into a double dip or to a stall-out.”

Fed on Course

Bernanke, 57, signaled in testimony this week that he will keep the Fed on course to complete the purchase of $600 billion of Treasuries through June to spur economic growth and hiring. The central bank chief didn’t rule out expanding the so-called quantitative easing program, saying he doesn’t want to see the U.S. relapse into a recession.

“The economy’s recovery is not firmly established, and we think monetary policy needs to be supportive,” Bernanke told the House Financial Services Committee.

Separately yesterday, the Fed said in its regional Beige Book survey that the labor market improved throughout the country early this year, driven by increasing retail sales and “solid growth” in manufacturing.

Overall, the economy “continued to expand at a modest to moderate pace,” the central bank said in Washington. Eleven of the Fed’s 12 regional banks, including San Francisco and Philadelphia, described their regions as expanding, improving or experiencing moderate growth. Only Chicago reported growth “at a pace not quite as strong” as before.

To contact the reporters on this story: Scott Lanman in Washington at slanman@bloomberg.net; Caroline Salas in New York at csalas1@bloomberg.net

To contact the editor responsible for this story: Christopher Wellisz at cwellisz@bloomberg.net

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