In construction, understanding the impact and implications of inflation, a critical economic factor, is essential to effective strategic planning and bidding. In this blog, we will discuss how inflation is affecting construction costs and bidding ideas.
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What Is Inflation?
Inflation refers to the general increase in prices of goods and services over time, resulting in a decline in purchasing power. In simpler terms, when inflation rises, each unit of currency buys fewer goods and services. This economic phenomenon affects all sectors, including construction, by increasing the costs of materials, labor, and other necessities for doing business.
So, prices go up over time…but why?
Prices tend to increase over time due to several interconnected factors:
- Economic Growth and Demand—As economies grow, consumer confidence and spending generally increase. Higher demand for goods and services can push prices upward. A growing economy is a good thing, unless it gets too “hot.”
- Monetary Policy—Many central banks aim for a low but positive rate of inflation (commonly around 2%) to encourage spending and investment rather than saving. A year-over-year inflation rate of 2% is considered optimal for sustainable economic growth.
- Increased Production Costs—Over time, the costs of labor, energy, and raw materials may rise due to scarcity, increased demand, or regulatory changes, leading to higher prices for finished goods.
- Technological Advancements—While technology can reduce costs in some sectors, it can also create new products and services that command higher prices due to innovation and added value.
- Global Economic Factors—Exchange rates, international commodity prices, and global supply and demand dynamics can make imports more expensive, contributing to inflation in the U.S.
When inflation remains around the target rate of 2%, a healthy economy chugs along, and price increases are offset by comparable business and income growth.
How Is Inflation Measured?
Inflation is commonly measured using price indices that track the average change in prices over time. The two primary indices are the:
- Consumer Price Index (CPI)—Measures the average change in prices paid by consumers for a basket of specific goods and services.
- Producer Price Index (PPI)—Tracks the average change in selling prices received by domestic producers for their output.
The construction industry also uses specialized indices like the Construction Cost Index (CCI) and the Building Cost Index (BCI). These consider factors specific to construction, such as material costs, labor rates, and equipment expenses, providing a more accurate reflection of inflation’s impact on the industry.
When Does Rising Inflation Become a Bad Thing?
When these indices show that prices are rising too quickly, climbing above the target inflation rate, businesses and individuals begin to feel the negative consequences. Money loses value, as each dollar can purchase less at higher prices. Central banks—in the U.S., the Federal Reserve—may raise interest rates to combat inflation by slowing down the economy. With increasing economic uncertainty, markets can become more volatile.
In the construction industry, these consequences of inflation mean that:
- Project budgets may not cover as much as initially planned.
- Higher prices for materials and labor can erode profit margins.
- Borrowing costs increase with rising interest rates.
- It becomes harder to predict future costs and revenues.
- Fixed-price contracts become riskier due to cost unpredictability.
The construction industry has felt the effects of high inflation acutely, experiencing project delays, budget overruns, and strained client relationships.
How Has the U.S. Inflation Rate Changed in the Last Decade?
From 2014 to 2020, the U.S. experienced relatively low and stable inflation rates, generally hovering around the Federal Reserve’s 2% target. However, starting in 2021, inflation began to rise significantly due to factors such as:
- Supply chain disruptions due to the COVID-19 pandemic.
- Greater spending from stimulus packages and pent-up consumer demand.
- A tight labor market, which drove up wages.
By mid-2022, inflation rates reached levels not seen in decades, with the CPI peaking at around 9% year-over-year. The Federal Reserve responded by raising interest rates to cool down the economy. As of late 2023, inflation showed signs of moderating but remained above pre-2014 levels.
At the end of the third quarter of 2024, the Federal Reserve saw enough improvement to cut the prime interest rate by .05%, and further cuts are expected moving into 2025. However, contractors still need to implement certain strategies to counter the effects of inflation.
How Can Contractors Mitigate the Impact of Inflation?
By proactively adjusting bidding strategies, contractors can better manage financial risks associated with inflation.
- Include escalation clauses that allow for price adjustments based on material and labor cost changes.
- Shorten project timelines to lock in prices and reduce exposure to future cost increases.
- Negotiate long-term contracts and bulk purchasing agreements with suppliers to secure current prices.
- Include risk contingencies when bidding by allocating funds to cover potential cost overruns due to inflation.
- Reduce dependency on single suppliers to mitigate the risk of price spikes.
- Be transparent in communicating with clients and keeping them informed about market conditions and potential impacts on project costs.
Ongoing actions by the Federal Reserve to control inflation may stabilize prices. And post-pandemic improvements in supply chain efficiency are alleviating shortages of essential building materials. But although many economists anticipate a gradual return to more moderate inflation levels in 2025, uncertainties remain.
International conflicts can disrupt supply chains and affect material costs. Continued labor shortages could keep wages high. And stricter environmental regulations could increase costs for certain materials and processes.
So, moving forward, construction professionals should stay informed about economic trends and remain flexible in their planning. Being agile and proactive will be key to success in an ever-evolving economic landscape.
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