Federal Reserve worry list gets longer---recession-hit U.S. state and local government finances.

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(Reuters) - The U.S. Federal Reserve's list of worries may be getting longer

A fading recovery, persistently high unemployment, Europe's debt troubles and commercial real estate losses have garnered most of the attention. But some Fed officials have begun talking more about another trouble zone -- recession-hit U.S. state and local government finances.

The problem is that they have to balance their budgets, unlike the federal government, which is running a deficit equal to more than 10 percent of total economic output.

"They have no choice but to cut spending or raise taxes -- or they get some more help from Washington," said Harm Bandholz, an economist with Unicredit in New York.

He thinks state and local government finances represent the most important domestic risk factor in the U.S. economy. Yet they received only two brief mentions in 19 pages of minutes from the Fed's April policy-setting meeting.

Minutes from the Fed's last meeting, on June 22-23, set for release on Wednesday, are likely to show the central bank trimmed its economic growth forecast, largely because of a run of disappointing data and fears of a European slowdown.

Bandholz said the Fed may be reluctant to say much more about state and local government budgets because that would involve treading into the realm of fiscal policy, which is the Treasury Department's responsibility.

But they may draw more attention as the problem gets worse. Next year's state and local government budget gap is expected to reach $140 billion, or a little more than 1 percent of gross domestic product. Considering economists expect GDP growth of only about 3 percent next year, that is a substantial hit.

In the first quarter of 2010, the most recent period for which full data is available, state and local governments subtracted 0.5 percentage point from gross domestic product. That was equal to the reduction from commercial real estate, a primary area of concern for the Fed.

The Fed may get more evidence this week that the economy stumbled into the summer. Economists are predicting weak U.S. June retail sales and a small decline in industrial output.

Also on this week's agenda is a batch of Chinese statistics, including second-quarter GDP, which is forecast to slow to a still-hot 10.5 percent from 11.9 percent.

GETTING WORSE

Government budget cuts weigh on economic growth because they can lead to job losses and spending reductions, as well as higher taxes that constrain consumer and business spending. In the first quarter, state and local governments reduced spending at a 3.9 percent rate, the steepest drop since 1981.

"This situation is our nation's very immediate analog of the public finance pressures being felt in Europe," Dennis Lockhart, president of the Atlanta Fed, said in a June 30 speech, one of a smattering of recent Fed references to state and local government budgets.

It is likely to become a bigger drag over the next 18 months. As part of last year's $863 billion stimulus package, the federal government gave money to help close state and local budget gaps. But the transfer payments peaked in the second quarter of last year and are running out.

This is evident in the GDP figures. In the second quarter of last year, when stimulus money flowed in, state and local governments added a half-point to U.S. economic output.

Second-quarter 2010 GDP figures won't be released until the end of July, but judging from the 34,000 jobs state and local governments cut over that period, it appears this segment once again subtracted from overall growth.

The Fed seems to be watching.

The Federal Reserve Bank of San Francisco published a research paper on "fiscal crises of the states" in late June, less than a week after the Fed's last policy meeting. (here)

In the paper, Fed researchers said both the central bank and private economists had factored the budget squeeze into their forecasts and considered it a "modest drag on growth." But they showed little concern that this would be enough to derail the shaky economic recovery.

"Historically, the health of the national economy determines the health of state finances, not the other way around," they wrote.

Some economists see a more serious problem. Paul Kasriel, chief economist at Northern Trust in Chicago, lowered his economic growth forecast for the rest of this year, in part because of the worsening condition of state and local budgets.

Goldman Sachs's Jan Hatzius said his 2011 economic growth forecast may be in jeopardy if states receive no more fiscal assistance from Washington.

"The point is that a tightening of the overall fiscal stance at a time when the economy is already struggling ... is a bad idea," he said.

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