Fed prepared to swing a bigger interest-rate stick before year’s end

Table: Associated Builders & Contractors

The Federal Reserve Bank’s interest-rate-raising campaign against inflation is designed to slow the economy but construction employment, work backlogs and costs are among parts of the economy where demand hasn’t yielded significantly to rising borrowing costs. It doesn’t bode well for 2023.

The unemployment rate for jobseekers with construction experience decreased to 3.4% in September, while unemployment across all industries fell from 3.7% in August to 3.5%. The Associated Builders and Contractors’ Construction Backlog Indicator increased to 9.0 months in September, according to an ABC member survey. The reading is 1.4 months higher than in September 2021.

Harder to correct a resilient economy

Graph: Associated Builders & Contractors

Even with Fed interest-rate hikes pushing the average rate on the most popular U.S. home mortgage to a six-year high, even with spending on new home construction falling 3.4% since its May peak, even with nonresidential-construction spending growth stalling, inflation persists and employment continues to grow. This economic resilience suggests the Federal Reserve will have to raise interest rates even faster to stabilize prices.

The Federal Open Market Committee (FOMC) has raised its target range for the federal funds rate by 300 basis points (or 3%) since March, the fastest pace of rate hikes in more than 40 years. With little impact on inflation, members of the Federal Open Market Committee are hinting at restricting monetary policy even more aggressively in the coming weeks.

“We had been looking for the committee to hike rates by another 100 basis points by early next year,” said Jay Bryson, Ph.D., chief economist at Wells Fargo Securities. “But recent developments have led us to believe that even more tightening lies ahead, and we now forecast that the FOMC will raise rates by another 175 basis points before it is finished tightening policy.

“The update to our forecast reflects, at least in part, the apparent resiliency of the U.S. economy in recent weeks. Nonfarm payrolls rose by 315,000 in August, well above the average monthly increase of roughly 190,000 that the economy generated during the long expansion of 2010 to 2019.”

The tight labor market has pushed average hourly wages up more than 5% over the past year.

“Not only have sizable wage gains helped to sustain consumer spending – real consumer spending likely rose again in August – but they are not consistent with an inflation rate of 2%, which is the Fed’s target rate,” said Bryson.

Is this construction’s peak?

Construction has borne a disproportionate inflation burden. Construction input prices dipped 0.1% in September, according to ABC analysis of this week’s U.S. Bureau of Labor Statistics’ Producer Price Index data. But construction costs are up 16.3% from a year ago. Input prices were down in September in six of 11 subcategories.

• Steel mill prices fell 6.7%
• Iron and steel prices dropped 5.4%
• Natural gas prices rose 3.1%,
• Crude petroleum prices were down 3.4%.

Overall producer prices expanded 0.4% in September, a larger increase than the consensus estimate of 0.2%.

“Today’s PPI release strongly suggests that there is no impending end to the Federal Reserve’s rate-tightening, which means that negative factors threatening the broader economy and nonresidential construction are only getting stronger,” said ABC Chief Economist Anirban Basu. “While nonresidential input prices fell slightly, inflation came in hotter than anticipated in the overall report. For contractors, the upshot is that they should be actively preparing their respective balance sheets for a downturn, even as many firms presently operate at capacity.”

The ABC Construction Backlog Indicator reached its highest level since May 2022 and exceeds the level observed at the start of the pandemic (8.9 months in February 2020). Backlog in heavy industrial construction increased sizably in September, spurred by a 21.5% year-over-year increase in manufacturing-related construction spending.

ABC’s Construction Confidence Index readings for profit margins and staffing levels increased in September, while the reading for sales moved slightly lower. All three readings remain above the threshold of 50, indicating expectations of growth over the next six months.

“The construction confidence and backlog metrics appear strong despite the U.S. economy facing headwinds like inflation, financial market volatility and rapidly rising borrowing costs,” said Basu. “Contractors remain decidedly upbeat, with backlog expanding and expectations for rising sales, employment and profit margins over the next six months.

“One would think the recent surge in interest rates would be enough to dampen contractor confidence. Instead, project owners continue to move forward with a significant number of projects. Faced with high demand for their services, contractors continue to show pricing power, helping to offset rising compensation and other construction delivery costs.”

Reckoning to come in 2023?

“While many American nonresidential contractors remain upbeat, there are significant threats looming over the industry,” said Basu. “Next year stands to be a weak one for the U.S. economy as it continues to absorb the impacts of rapidly rising borrowing costs.

FOMC members predict the federal funds rate will have to climb as high as 4.5% to 4.75% in 2023 and some are expecting no rate cuts next year. The assumption is that the economy will tip toward recession at that borrowing cost and the Fed is prepared for all of us to ride it out to confirm that prices are decidedly headed toward their 2% inflation target.