What causes inflation, how does it affect infrastructure, and how can governments manage it? ICE policy fellow Steve Lee explains.
“How much?!” A phrase many of us have exclaimed over the past year in response to rising costs.
Last July, I was in Australia when the price of a single red pepper had risen to AUD $5 (about £2.60) after floods devastated farmlands and caused food prices to soar.
But Australia, like many nations worldwide, was already experiencing a cost-of-living crisis.
In the UK – a country obsessed with the weather – climate is barely a factor.
Why is inflation so high right now?
Rising commodity prices (causes for which include the war in Ukraine and rebound from Covid lockdowns), material costs, supply chain shortages, and increasing consumption are pushing up prices globally.
Labour shortages are another significant factor. According to the latest Construction Skills Network (CSN) report, the UK needs 225,000 new construction workers by 2027.
Higher demand for workers means higher wages. In addition, people are also demanding higher pay to compensate for higher living costs.
This relationship between wages and prices risks causing a ‘wage-price spiral’.
The ‘wage-price spiral’ theory
- Workers ask for higher wages to accommodate rising prices.
- Employers raise prices to accommodate higher expenses.
These cyclical effects can become a spiral that causes a prolonged period of inflation.
How high is UK inflation?
UK inflation is currently at 7.9%, against a target of 2%. It peaked in October 2022 at 11.1%.
For comparable figures, you must go back decades.
The 11.1% peak was the highest annual inflation rate since 1981 (the Consumer Price Index series we use today to measure inflation begins in January 1997).
Therefore, in recent times, the rate of inflation is unprecedented.
How has inflation changed over time in different countries?
The G7 economies have suffered periods of high inflation in the past – most notably during the 1970s energy crisis, when fuel shortages caused prices to shoot upwards.
Between 1974 and 1977, the UK and the US introduced a maximum speed limit of 50mph on roads to reduce energy consumption.
Energy, again, is the primary cause of inflation today.
This is prompting governments to reevaluate their policies towards energy security.
How do interest rates affect inflation?
Policymakers and central banks use interest rates as the main tool to control inflation.
Raising interest rates reduces consumer spending, as it becomes more expensive to borrow money and repaying existing loans become more costly.
Interest rates can be a blunt instrument.
Raised too quickly, they can send an economy backwards – stifling growth or causing a recession.
Raised too slowly, however, they can fail to reign in rising prices.
The relationship between infrastructure and inflation
The construction industry keenly feels the impact of inflation.
During periods of inflation, governments and investors must make hard decisions about priorities and affordability.
At a government level, rising inflation means major projects need deferring or rescoping to save money.
Consultants and contractors see profit margins narrow, and smaller suppliers face the threat of insolvency as they struggle with rising costs, growing loan repayments, and remaining competitive.
Inflation has long cast its shadow over the industry.
Thinking back to 2010-2011, developing and designing projects for the London 2012 Olympic and Paralympic Games, inflationary pressures and increasing tender prices were challenging my teams to make our designs more efficient.
How are governments around the world managing the impact of inflation on infrastructure?
The United States Inflation Reduction Act of 2022 is a significant piece of legislation.
It proposes a range of fiscal measures to reduce the federal government deficit and lower inflation.
It also offers billions of dollars in subsidies and tax credits to encourage private investment in green infrastructure and technology.
In so doing, it aims to reduce inflation by reducing the cost of energy. And alongside the Infrastructure, Investment and Jobs Act, it’s making the US an attractive place to invest.
The EU is responding by reviewing state aid provisions and a Green Deal Industrial Plan.
Rather than directly matching the US by deploying new funds, the EU is mainly simplifying the regulatory environment.
In the UK, the Chancellor has indicated the approach "will be different – and better". We eagerly await the autumn statement.
What about countries that are historically more accustomed to high inflation?
For some countries, high inflation is a far more regular and longstanding phenomenon.
In Turkey, for instance, annual inflation hit a peak of 85.5% in October 2022.
Despite this, the Global Infrastructure Hub reports that Turkey has managed to increase investment, resulting in some of the highest-value public-private partnership (PPP) infrastructure deals and private infrastructure investments globally.
Continuing strong investment has been partly due to Turkey’s unusual stance of lowering interest rates at a time of high inflation.
‘Real’ interest rates in Turkey are negative, making saving money more costly than borrowing and spending.
How infrastructure can respond to inflation
Well-planned infrastructure can help promote economic growth and improve productivity.
Delaying or mothballing projects rarely reduces costs.
Clear priorities and decision-making incentivise investment, keep costs down, and ensure projects deliver value for money.
This can help mitigate inflation in the longer term.
After all, what goes up must come down.
Red pepper prices in Australia have returned to a more normal price of AUD $0.97. Much more digestible.
In case you missed it
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