What’s the deal with inflation and interest rates? Inflation has been, unfortunately, a hot topic as of late. In the wake of COVID-19, inflation has caused rising prices and unpredictable market conditions that affect everyone from individuals to global businesses. Add in rising interest rates and it’s easy to see how the American economy can suffer.
The construction industry is no exception. Developers, contractors and investors are all acutely aware of rising inflation’s impact on the industry. Specifically, increases in borrowing costs, labor costs and material costs all affect the profitability and viability of construction endeavors for industry actors.
However, the construction industry may be poised for a breakthrough as we progress through 2025. As interest rates begin to ease, many in the world of construction are cautiously optimistic that a rebound is coming. Nonetheless, the effects of inflation and high interest rates always linger. Understanding how these factors interact is crucial for industry professionals looking to capitalize on emerging opportunities.
Inflation + High Interest Rates = Sluggish Economy
Inflation and interest rates are closely related, and both have significant impacts on various sectors of the economy. Increased costs of goods, services and wages are results of inflation. With these increased costs come the decreased purchasing power of individuals and businesses alike. Periods of high inflation have historically been a pressure point for the construction industry due to rising expenses for labor and materials such as lumber, steel and concrete. As these costs increase at a project site, profit margins fall or disappear altogether.
Texas is not immune from inflationary pressures. Between 2020 and 2023, inflation caused project costs in Texas to surge by 30%. This increase was mostly attributable to high interest rates, material costs, labor costs, and difficulties obtaining financing. This most recent period of high inflation led to numerous stalled or cancelled construction projects across the state.
When inflation is high, the Federal Reserve will often raise interest rates. Increasing interest rates is a tool aimed at slowing down spending and curbing inflation. Essentially, the effect of raising interest rates is that borrowing becomes more expensive so spending decreases at the individual and business level.
On the other hand, when inflation stabilizes, the Fed may lower interest rates to encourage borrowing and investment. The construction industry benefits greatly from stable inflation and low interest rates due to its heavy reliance on financing and material costs.
Low Inflation + Low Interest Rates = Bullish Economy
Currently, the United States is experiencing a cycle of declining interest rates, which is likely to facilitate borrowing and stimulate spending. These changes are expected to have sweeping effects on the American economy, particularly in construction. Some of those changes are already benefitting the Texas construction industry.
For instance, the Inflation Reduction Act spurred a generational boom in contract values for nonresidential and nonbuilding construction in Texas. Specifically, Texas alone has been responsible for more than $289 billion of U.S. nonresidential and nonbuilding construction contracts over the past three years. That $289 billion translates to roughly 16.5 percent of the total value of U.S. nonresidential and nonbuilding construction contracts. The state’s built-in advantages should give construction actors in the state confidence that this trend will continue.
As interest rates and inflation begin to ease, economists are optimistic about the national construction market’s performance in the coming years. Understanding how declining interest rates and decreased inflation affect the construction industry is crucial for stakeholders so that they can navigate these changes and utilize their benefits effectively.
The Positive Impact Decreased Inflation has on the Construction Industry
Easing inflation has the potential to benefit the construction industry in many ways. Specifically:
- Stable material costs. Prices for construction materials like lumber, steel and concrete surged during the recent periods of high inflation limiting the profitability of construction. Eased inflation has historically led to a stabilization or decrease in material costs. Cheaper materials will make projects more cost-effective and profitable.
- More predictable labor costs. While labor costs are unlikely to drop, lowered inflation can help slow the rapid increase in wage cost seen over the last few years. This stability allows contractors and developers to forecast labor expenses without the fear of unexpected spikes.
- Increased project feasibility. Profit margins for developers and contractors are expected to rise in light of more stable material and labor costs. Projects that were previously postponed due to high costs may now become financially viable, leading to a resurgence in new construction activity.
- Investor confidence. Developers, lenders and stakeholders may be more willing to commit to new projects, knowing that economic conditions are becoming more predictable.
While none of the above points are guaranteed, historical trends should give interested parties confidence that decreased inflation will boost the construction industry.
The Positive Impact Lowered Interest Rates have on the Construction Industry
Interest rates, like inflation, play a significant role in the construction industry. Interest rates most directly influence borrowing costs and overall project feasibility. Recently, there has been a 100 basis point cut in interest rates. This reduction pattern is anticipated to continue further into 2025, providing a favorable environment for construction activities. Some economists, such as Richard Branch, chief economist at Dodge Construction Network, predict that these cuts will lead to an additional 8.6 percent rise in construction starts in 2025, building on the already significant increases realized at the end of 2024.
Although lowered interest rates will, in general, positively impact the construction industry, individual construction sectors may experience varying levels of growth.
Residential Construction
For instance, the residential construction sector is expected to benefit significantly from these changes. Dodge estimated a 7.8 percent increase in residential work in the final months of 2024, and also predicts an 11.5 percent rise in 2025. While multifamily projects declined in 2024, a rebound is anticipated in 2025 as vacancy rates stabilize. This positive outlook suggests that the residential market will strengthen despite the recent challenges posed by inflation.
Non-Residential and Non-Building Construction
While the growth may not be as robust, the non-residential construction sector is also anticipated to expand. This increase in volume will likely be driven by sectors such as hotels, retail and healthcare. Non-residential projects had an estimated rise of 5.7 percent in the closing months of 2024 and are predicted to rise an additional 5.9 percent in 2025. Finally, federal funds are expected to boost non-building construction, such as highway and bridge projects, with an 8.8 percent rise projected in 2025.
Challenges and Opportunities
Despite these positive trends to close out 2024, interest rates and inflation continue to pose challenges for the construction industry. Michael Guckes, chief economist at ConstructConnect, notes that total construction spending was down 0.2 percent year-over-year in 2024 due to financial constraints. However, he remains optimistic about a rebound in spending now that interest rates are on a consistent decline.
Stakeholders should closely monitor economic trends, material costs and policy changes to make informed decisions. While inflation may not disappear overnight, declining interest rates provide a much-needed tailwind for construction growth.
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