An unbalanced load - the economic double whammy weighing us down

Andy Beard is global head of cost and commercial management at Mace. In the first of a two-part analysis, he looks at the ongoing impact of inflation and high interest rates on the construction sector



With personal finances taking a beating, interest-rate rises and inflation are topics on the lips of the nation, but what does the dastardly duo mean for construction?

On the back of stubbornly high inflation, the Bank of England has raised interest rates to 5.25 per cent. Another increase in September is on the cards, and while this may be the end of the tightening, if inflation doesn’t come down as quickly as expected, risks exist that the bank’s Monetary Policy Committee (MPC) will have to act again later in the year.

Having seemingly avoided a recession as a result of higher energy costs, there is now a significant risk that higher interest rates and the associated impact on mortgage repayments will drag us back in that direction.

With the inflation rate unchanged in May, rates were aggressively hiked by 0.5 per cent. Then June’s inflation figure, noticeably down at 7.9 per cent, allowed the MPC to raise rates by just 0.25 per cent at their latest meeting, but inflation is still uncomfortably high.

However, the problem stems from well before these recent figures. Inflation had initially started rising after the pandemic due to supply chain problems, and then the invasion of Ukraine led to a spike in energy prices. Now, we are seeing higher wages feeding through into price rises and, let’s be clear, Brexit has not helped with any of this.

But still, it is the bank’s job to manage such shocks, and it has failed to do so. The MPC first raised interest rates in December 2021, at which point inflation was already at over 5 per cent. It was a case of ‘timing is everything’, with the Covid furlough scheme already having ended a couple of months earlier; an earlier move ran the risk of tightening things at a time when unemployment figures were on the brink of damaging rise.  

As it was, the end of furlough didn’t result in a rise in unemployment, but the bank’s decision to follow this initial move with four quarter-point increases opened it up to the criticism that it didn’t respond to the state of the economy and rising inflation fast enough.

Against this backdrop, the concern is now that, in trying to dampen demand enough to bring inflation under control, the bank may cause a more severe economic slowdown, particularly in some sectors. While it would seem unimaginable that the bank is trying to manufacture a fall in GDP and the potential recession this could bring, there is an impression that it may be willing to accept such an outcome.

Data doesn’t lie

In saying this, it’s important to explain why the bank is taking these decisions. It believes that acting strongly is necessary to prevent more forceful interest rate rises later. Ongoing increases in pay are also starting to cause a wage-price spiral and the latest rate rises are an attempt to curb them from becoming more entrenched.

Whatever the rationale, these moves spell bad news for the construction and built-environment industry. This is partly because of the sector’s reliance on borrowing and partly because inflation in the sector has been more substantial than elsewhere.

I wish I could paint a more positive picture, but the data doesn’t lie.

The consumer price index – which measures the average change from month to month in the prices of goods and services purchased by most households in the UK – rose by 18 per cent between the first quarter of 2020 and Q1 2023. Meanwhile, the Building Cost Information Service’s (BCIS’s) Building Cost Index increased by more than 23 per cent. Even though things are improving, and the Department for Business and Trade’s ‘all work construction material price index’ is now 2 per cent lower than a year ago, it will be a long time before material price pressures truly end and, relative to the start of 2022, it is still up 12 per cent.

Impact of house prices

More importantly, housing, the sector that will suffer most under higher interest rates, has seen an increase in costs of 31 per cent, according to further BCIS data. The causes behind this are many, with higher input costs, a coalescing of building regulations and extra costs due to the effort to reduce carbon emissions and boost biodiversity all taking their toll. Add to this the costs associated with planning (a longstanding sectoral challenge) and land acquisition (slow to adjust), and it’s hard to deny a storm is brewing.

Higher costs in the sector wouldn’t be such an issue if house prices had kept up. So, while they have also risen rapidly – increasing 24 per cent in the three years since the start of the pandemic, and up 8 per cent last year – this was not enough to keep up with the cost of building houses. Returns for many homebuilders were, therefore, already falling before the latest increases in interest rates.

And the trend is set to continue.

We’ve seen house prices fall in the first half of the year. Soaring mortgage costs mean the amount that homebuyers are willing and able to borrow is falling, which, in turn, is causing demand to fall and will lead to further reductions in house prices. Some of the more extreme forecasts suggest prices could fall by more than 20 per cent. With build costs unlikely to drop anytime soon, it looks bleak for homebuilders’ profits per unit sold. What’s more, the viability of schemes will come into question, with a pause in output almost certainly becoming a realistic option for some.

Growing gap between house prices and build costs

All of this has significant implications for our industry. Within the category of new work, not including repairs or renovations, new housing makes up over 40 per cent of output. Accounting for such a large share means a downturn in building new houses will cause the wider construction and built-environment sector to reduce in size. This was already happening, but recent events are almost certain to enforce a more sizable drop.


This article was originally published by Construction News


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