Getting Back To ‘Normal’

Forecasting inflation for next year is more dicey than usual. The housing market is teetering at record levels and many economists predict it will stumble from this peak in 2006. In addition, the consensus among economists is that the rebuilding effort along the Gulf Coast will unfold slowly, that energy markets will gradually come back into equilibrium and that the Chinese economic juggernaut will pause, easing global demand for materials. These are all major turning points, at which predictions become most precarious.

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With the above economic assumptions on the table, ENR predicts that year-to-year inflation measured by its Building Cost Index will subside to 1.5% by next December. This would be a sharp drop from the 5% recorded this year and the 9.7% for 2004. ENR’s Construction Cost Index, which is more heavily weighted toward labor costs, is predicted to increase 2.8% next year, after increasing 4.6% during 2005 and 7.8% the previous year.

If these forecasts hold, it will bring inflation back into the range it was held in between 1993 and 2003. Should housing once again defy predictions of a slowdown, something it has done for the past several years, or, if election-year pressures kick up the Gulf Coast rebuilding effort, then inflation could come in several percentage points higher than expected.

While the annual escalation rate of ENR’s indexes is expected to ease there will still be inflationary hot-spots in 2006. This year’s most troublesome products have been oil, plastic and copper-based products. None of these are directly reflected in ENR’s indexes and all should remain volatile through 2006.

This year, Hurricane Katrina severely disrupted natural gas supplies, which almost immediately led to a spike in PVC pipe prices. ENR’s 20-city average price for PVC water and sewer pipe ended the year with annual increases between 20 and 35%. Before Katrina, PVC pipe prices were posting annual increases between 6 and 10%.

“Copper prices have been going up at about the same rate as PVC prices,” says Julian Anderson, principal with Rider Hunt Levett & Bailey. He says copper wire prices jumped about 20% during the last three months. “Overall, the trend of stronger material price escalation is sticking,” says Anderson. “I expect general escalation in 2006 to be about the same as this year,” he adds.

Diesel fuel prices also are expected to remain high. This year, diesel fuel prices posted a 59% year-to-year increase, according to the Bureau of Labor Statistics producer price index for October. “Higher fuel prices have led to stiff surcharges for the delivery of materials,” says Mary Wallers, president of Sierra West Group, which compiles the Lee Saylor cost index. She says delivery surcharges have been reported between 10 to 25%.

Main Index Drivers

The most critical element in forecasting ENR’s indexes is labor costs, which account for 80% of the CCI and 64% of the BCI. A year ago, ENR’s forecast called for a 4.4% increase in the CCI’s labor component and a 4.1% increase for the BCI’s labor component. The actual increase for both was 4.2%.

Once again, ENR is forecasting that the labor component of its indexes will hold close to the increases already negotiated for next year. Multiyear collective-bargaining agreements reported by the Construction Labor Research Council, Washington, D.C., call for another 4.3% increase in 2006.

For the last two years, material price escalation has been the main driver of inflation. Steel prices, which account for 20% of the BCI, followed 2004’s 31% increase with another 13% increase this year. This was about 2% more than ENR had predicted a year ago.

“By the fourth quarter of 2006 structural steel prices should decline 6%, to $534 per ton,” says John Anton, steel analyst for the forecasting firm Global Insight, Washington, D.C. He expects imports from China to increase significantly, helping to pull prices down. This will be countered by rebuilding efforts in the Gulf Coast area. “There are two strong forces pushing steel prices in opposite directions,” says Anton. ENR believes the tug on prices from rebuilding will be delayed into 2007 and is projecting the indexes’ steel component to decline 3% by next December.

Lumber is the next largest materials component of ENR’s indexes, accounting for 14% of the BCI. Last year, ENR predicted lumber prices would fall 8.7% in 2005 but the housing market stayed strong and prices only declined 2.3%. “The key is that prices still declined despite record demand,” says Paul Jannke, vice president of wood products for the forecasting firm Resource Information Systems Inc., Bedford, Mass. The reason is that total industry capacity increased, from 79.7 billion to 81.9 billion board ft, he says.

“It is pretty hard to imagine demand in 2006 being stronger than 2005 and capacity should continue to increase, reaching 83.5 billion board ft in 2006,” says Jannke. With demand at best remaining stable, combined with increased supply, RISI is looking for across the board price cuts of 10 to 13% by next December. ENR is forecasting the lumber component of its indexes to decline 5% during the same period.

Portland cement is the third materials component of ENR’s indexes and it increased 4.7% this year, just 0.2% more than ENR predicted a year ago. In 2006, ENR expects cement prices to increase another 2.7%. “Rising imports and a weaker housing market will flatten out cement prices,” says Michele Halickman, an analyst with Global Insight. She predicts that the BLS producer price index for cement will only increase 0.8% next year, after rising 5.5% in 2005.

ontractors should get some relief in 2006 from two years of intense material price escalation. The explosion in steel prices in 2004 was followed by stiff price hikes for cement and lumber. This year, gypsum wallboard and energy, plastic and copper-based products all posted large double-digit price hikes. An anticipated slowdown in the housing market combined with increased imports and producer capacity will put a cap on escalation. However, price declines will be modest compared to the increases of 2004 and 2005. International inflation rates also are easing, with the average rate for 30 countries falling back to 4.9% this year after jumping to 6.3% in 2004.