Better news on construction costs
One of the most consistent themes in data for the March quarter has been the moderation in pricing pressures. The most high-profile example was the easing in consumers price inflation from 7.2% to 6.7%pa, with the index’s rise of 1.2% from December being the smallest quarterly increase in two years. Although inflation remains elevated, the fact that it has started to head in the right direction has given the Reserve Bank the confidence to declare the official cash rate is on hold for now.
For the construction industry, the first hint of a significant softening was the “purchase of housing” category in the Consumers Price Index, which rose by 1.1% in the March quarter. This increase was the smallest quarterly lift for 2½ years. Improvements in the supply of workers, with a range of construction roles included on the government’s immigration Green List, in tandem with residential construction activity starting to ease from its peak, has helped drive the moderation in cost growth.
The Capital Goods Price Index, which includes our preferred measures of construction costs, confirmed the slowdown in building cost inflation. Chart 1 shows that annual cost inflation across all three construction types was at its slowest in 12-18 months, and the quarterly increases of 1.4% in residential costs and 0.1% in civil construction costs were the smallest since late 2020 or early 2021. Only non-residential building costs, which rose 1.9% in the March quarter, were stronger than our forecast.
Although the drop-off in demand and improvement in labour supply were both factors behind the moderation in construction cost growth, detailed data from the Producers Price Index showed a range of input costs falling in price in the March quarter (see Chart 2). One should interpret many of these cost movements with care, because there had been significant cost rises in previous quarters. For example, despite falling 12.7% in the March quarter, diesel prices were still 8.1% higher than a year earlier. Similarly, prices for fabricated metal products were 11.3% higher than in March 2022, even with a 0.9% decline in the latest quarter.
Some easing in materials costs will be welcome news for people in the construction industry, following two years of supply chain disruptions, high international shipping costs, and regular price rises for products. The weaker global economic outlook has helped to take the heat out of international commodity prices and shipping costs, and softening demand within New Zealand will also reduce the imbalance between demand and supply, helping to alleviate cost pressures.
Inflation expectations ease as demand softens
Along with the moderation in actual inflation in the March quarter, there has also been a sizable easing in inflation expectations since the start of this year. One of the Reserve Bank’s key indicators, looking at inflation two years ahead from its Survey of Expectations, has pulled back from 3.62% to 2.79% since the December 2022 quarter, and is now at its lowest level since September 2021 (see Chart 3). This trend is repeated across several other expectations measures, including the Reserve Bank’s one-year-ahead measure, the inflation expectation measure from ANZ’s Business Outlook survey, and several cost and price measures from the NZIER’s Quarterly Survey of Business Opinion (QSBO). Although many of these indicators remain elevated by historical standards, the direction of the trend provides a measure of confidence that pricing pressures will continue to moderate over the next two years.
Perhaps most critical for the construction industry is the dramatic change in trading conditions over the last few quarters. One of the questions in the QSBO asks businesses what single factor is limiting their ability to increase turnover. Chart 4 shows that just 4% of builders in the March 2022 quarter chose demand as the biggest constraint – the record low prior to COVID-19 was 28%. Labour, capacity, and supplies were all bigger limitations. However, between December 2022 and March 2023, the proportion of respondents that nominated demand as the biggest constraint jumped from 25% to 64%, in line with its long-term average. This shift in demand conditions is set to reduce the scope for further price increases going forward.
Risks of inflation pockets persisting into 2024
Nevertheless, the broad environment of easing construction cost inflation is not without its risks. Recent modelling of civil construction costs we have done points towards the possibility of a mini-resurgence in cost inflation during 2024 due to several possible factors.
- Long lead times associated with plant and machinery imports mean that pricing for some of these products has yet to fully reflect the upward pressures seen during 2022. Above-average increases in plant and machinery costs could persist until mid-2024, and these pressures could be exacerbated by weakness in the New Zealand dollar.
- Although labour shortages have improved due to the migration influx, there are likely to be some residual wage pressures persisting for another 6-12 months as workers grapple with the rising cost of living. Furthermore, the construction roles on the immigration Green List are mostly concentrated in vertical construction, meaning that labour shortages and wage pressures could be more persistent for the infrastructure subsector.
- The reinstatement of higher fuel excise duty on petrol and road user charges for diesel vehicles at the start of July could have significant flow-on effects for domestic freight costs. The saving grace is that, at the moment, diesel prices are 39% ($1.17/L) lower than at their peak in July last year, and international refining margins for diesel appear to have returned to normal. Even so, freight costs look unlikely to get any more favourable than they are now.
- Strong demand conditions in the infrastructure subsector could also maintain pressure on costs, particularly in comparison to the residential subsector, where demand is clearly easing. The strength of demand for infrastructure work reflects major programmes of pre-existing work overlaid with significant repair and recovery work following the extreme weather events earlier this year.
Although we expect construction cost inflation to continue slowing over the next 12-24 months, clear challenges to this outlook remain – as is the case for the economy more broadly, as the Reserve Bank struggles to dampen the inflationary mindset that has spread across the economy throughout the last couple of years.