What two months of slowing inflation mean for construction and interest rates

By Larry StewartDecember 14, 2022

Inflation surprised economists in November, slowing to 7.1% over the previous 12 months from 7.7% growth in the October, according to new U.S. Bureau of Labor Statistics Producer Price Index data. It was the second month in a row for slowing inflation, and the smallest year-over-year increase since December 2021. Construction input prices also showed significant relief.

Nonresidential construction backlog increased in November, suggesting continued pressure on labor costs (record November construction employment inflated wages faster than the average for all production workers) and adding diverging data points to interest-rate deliberations by the Federal Reserve Board’s Federal Open Market Committee this week.

Coming into the week, the Fed had already raised the Federal Funds Rate (the rate banks charge each other to borrow or lend excess reserves overnight) four times since May. Three increases of three-quarters of a percentage point followed along with steadfast FOMC messaging about persistence in applying restrictive lending policy to slow the economy and stabilize prices. The Federal Funds Rate rose from near zero early this year to a range of 4.25% to 4.50% with FOMC members approval of another half percentage-point increase on Wednesday.

Despite recent softening of inflation, the FOMC signaled rates are likely to head even higher and stay elevated throughout next year. The median estimate for the fed funds rate at the end of 2023 rose to 5.00% to 5.25%. The median committee member expects the fed funds rate to remain above its longer-run estimated rate of 2.5% through 2025 in a sign that even once easing commences, Fed monetary policy is likely to remain tight.

“All in all, while it appears the end of the tightening cycle may be coming into view, the start of an easing cycle remains some ways away as fully wringing out inflation looks more difficult,” said Sarah House, senior economist at Wells Fargo Securities.

“The FOMC will continue to be guided by the data in the coming months as they calibrate the degree of restrictive policy needed to bring inflation back to the 2% target.”

The toll on construction

Mortgage costs have soared with the interest-rate hikes of 2022, significantly slowing the single-family housing market. Slowing single-family housing sales have pushed multifamily occupancy rates up and driven rent increases.

(Graphic: Associated Builders and Contractors)

The November price-index report found that November rent rose 0.8% over October. Rent makes up a large chunk of the consumer price index, and few economists expect to see rents ease before well into 2023.

“Although inflationary pressures are cooling in some areas, overall costs for construction are still rising at painfully high rates,” said Ken Simonson, the Associated General Contractors of America’s chief economist. “In addition, subcontractors are reacting to higher materials and labor costs by raising their prices.”

The producer price index for inputs to nonresidential construction – the prices charged by goods producers and service providers such as distributors and transportation firms – rose 10.1% since November 2021 despite decreasing from October to November. The year-over-year rise outpaced the 7.4% increase in the overall producer price index for finished goods, the economist noted.

Prices of numerous widely used goods posted double-digit increases over the past 12 months. The producer price index for diesel fuel leaped by 59.6% despite a one-month decline of 3.4% in November. The index for paint and other architectural coatings rose 26.3% over 12 months. There were also increases of more than 10% annually in the price indices for:

  • gypsum products such as wallboard (18.0%)
  • insulation products (14.3%)
  • asphalt and tar roofing materials (12.5%)
  • flat glass (12.3%)
  • plastic construction products (11.3%)
  • truck transportation of freight (11.1%)

Products used in highway and heavy construction also experienced double-digit price increases from November 2021 to last month. The index for liquid asphalt, used in paving projects, jumped 19.8%, while the index for concrete products climbed 14.3%.

Subcontractors’ prices for new, repair, and maintenance work also increased sharply in the latest 12 months, including:

  • 20.8% for roofing contractors
  • 15.0% for plumbing contractors
  • 13.8% for electrical contractors
  • 10.9% for concrete contractors

Association officials urged public officials and private sector developers to factor in higher construction costs when planning for new construction projects.

Is the cost tide turning?

The Associated Builders and Contractors focuses on the decline in construction input prices November to October. Nonresidential construction input prices declined 0.8% for the month.

(Graphic: Associated Builders and Contractors)

Perhaps looking for the turning point, ABC notes that prices were up for the month in only four of the 11 subcategories. Natural gas prices fell the most – 15.8% in November. Unprocessed energy prices declined 7.8%, while crude petroleum prices were down 2.3%.

“The decline in wholesale prices for many construction inputs is generally positive news,” said ABC Chief Economist Anirban Basu. “Increasingly, we are receiving news that construction-input inflation has peaked as supply chains continue to normalize despite a range of geopolitical stressors. In November, much of the relief emerged from lower energy prices. According to ABC’s Construction Confidence Index, contractors are already expecting growth in sales and employment levels over the next six months; this report will do little to curb that optimism.

“As always, there is more to this report than meets the eye,” said Basu. “Prices for various economic services grew faster than expected, a reflection of a still very strong labor market associated with substantial compensation growth. Therefore, while supply chains may be improving, helping to moderate the price of physical inputs, contractors will continue to face elevated and rising human capital costs. This may explain why just as many contractors expect profit margins to decline over the next six months as expect them to expand.”

Backlog to keep wages rising

The ABC Construction Backlog Indicator increased in November to its highest level since the second quarter of 2019. The reading is 9.2 months, a level 0.8 months longer than in November 2021. Much of the increase is attributed to contractors with under $30 million in annual revenue, a group that now has its longest backlog in over three years.

ABC’s Construction Confidence Index reading for staffing increased in November. Staffing, profit margins and all remain above the threshold of 50, indicating expectations of growth over the next six months.

“The rise in backlog is remarkable and unexpected,” said Basu. “A number of contractors have been reporting that their backlog has risen rapidly over the past three months, which is counterintuitive given the pervasive view that the broader economy is headed into recession.”

Backlog improved sharply for contractors in the commercial and institutional work category, and health care-related construction emerged as a major driver of new activity.

“While it seems unlikely that backlog will hold up in the face of the Federal Reserve’s efforts to slow demand, many predicted that backlog would have dipped by now and that has yet to transpire,” said Basu. “What’s more, many contractors expect sales and staffing levels to climb over the next six months, while profit margins are projected to remain stable.”

Updated 12/14/2022 with information and commentary on the Federal Open Market Committee’s meeting and decision.

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