In May, the state estimated that Fiscal Year (FY) 2021-22 would start with a projected surplus of $97.5 billion. That rosy forecast has failed to blossom and now the state may have a $7 billion deficit for the current fiscal year and a possible $25 billion deficit for the fiscal year beginning July 1, 2023.

“It’s the economy,” as James Carville said in 1992. With inflation significantly greater than it had been for years, the Fed has taken actions to stop it and lower it. The Fed’s principal tool to moderate inflation is interest rates.

The fed began raising interest rates earlier this year and as rates increase, demand for borrowing, for goods, for houses declines. The effect of these declines should corral inflation; however, the accompanying pain will be less demand and fewer jobs with lower profits and wages.

The stock market falls as interest rates rise and that affects capital gains, which is a significant source of California revenue.

The Legislative Analyst’s Office (LAO) released its latest budget and revenue projects on Nov. 17. Its report warned state Legislators, “Some impacts also can be seen in state tax collections. For example, estimated income tax payments for 2022 so far have been notably weaker than 2021, likely due in part to falling stock prices.”

The LAO cautioned that these estimates are only based on the current level of interest rates and economic growth. If the country were to slip into a recession, then the revenue estimates would fall further.

In fact, the LAO acknowledged that it is pessimistic about the economy’s future. “The chances that the Federal Reserve can tame inflation without inducing a recession are narrow. Despite recent interest rate increases, inflation remains well above the Federal Reserve’s stated price stability goal … heightened inflation pressures could remain for some time. These observations suggest that the Federal Reserve will take additional steps to curb inflation in the coming months, further raising the risk of a recession.”

As the state’s revenues fall, there is a budget problem, which the LAO defines as “a deficit.” This is a problem because the state constitution requires the Legislature to pass a balanced budget.

The tools to achieve a balanced budget include reducing spending, raising taxes and using the reserves. During the past several good years, the state has built a reserve of nearly $24 billion. However, this would not be sufficient to cover the full deficit projected for the next three years.

So, some combination of budget reductions and increasing revenues are likely in the near term. Gov. Gavin Newsom will release his proposed FY 2023-24 budget in January and the Legislature will hold hearings, a revised budget project will come in May and a final budget in June.

Some specific suggestions were included in the LAO report. The state’s retirement payments to CalPERS may be higher than required and if reduced, some savings would occur. However, the federal augmentation of Medicaid due to the COVID pandemic will likely end next year and require increased state funding for these health programs.

The LAO did recommend preserving the reserves unless an actual recession occurred.