Construction Inflation in the Public Sector - The Case for Bonding
- 2 days ago
- 8 min read
The rate of construction cost inflation peaked at high levels in 2022 and 2023, by some measures exceeding 20% on a 12-month trailing basis. After declining to a low point in 2024, it is now on an upward trajectory once again. This poses a dilemma for public sector issuers: should an issuer postpone construction plans and accompanying bonding in anticipation of another lull in construction inflation, or should it fund construction through long-term bonding or a bridge financing such as a bond anticipation note as soon as practicable in order to get ahead of future cost increases? Our view is that, for many issuers, the relationship of tax-exempt borrowing rates to construction inflation likely justifies proceeding with borrowing for established multiyear plans of finance on schedule, without delaying projects for a potential uncertain improvement in financing costs and/or construction expenses. The relationship of construction inflation to tax-exempt rates and its current trajectory both point to this conclusion.
The overall pattern of changes in construction inflation since the COVID crisis is clear, though the specific measures of it have changed in subtly different ways, depending on what each one emphasizes. Furthermore, any single index that works for one type of public sector project might not be the best for another. Add to that regional variation and differential regulatory regimes across jurisdictions and it is necessary to examine multiple published measures from public and private sector providers to see which one is most applicable in a particular situation and how they compare to each other.
The Producer Price Index
The broadest and most quoted headline measure of input costs in the economy is the Producer Price Index by Commodity: Final Demand, seasonally adjusted (PPIFIS), maintained by the Bureau of Labor Statistics (BLS) and published on the Federal Reserve Economic Data site (FRED). PPIFIS covers inflation for goods, services, and construction that are sold to final demand. This includes governments buying materials for capital investment and construction. While this index is too broad and comprehensive to be solely indicative of construction inflation, it is often viewed as an early indicator of raw cost increases that may subsequently translate into both construction and consumer inflation. Below is a graph of 12-month trailing PPIFIS, showing an upward trend since mid-2024 with recent readings in the 5.5% to 6.0% range.
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Private Sector Measures
The Turner Building Cost Index (TBCI), the Engineering News-Record Building Cost Index (ENR BCI) and the Rider Levett Bucknall (RLB) Index are used by the private sector to measure labor and materials costs for a broad range of construction projects. The TBCI and RLB Index are broad nationwide assessments of actual building costs, including labor rates and productivity, while the ENR BCI relies on a specific basket of labor, steel, cement and lumber inputs in 20 cities. The annual change in the TBCI time series shows a gradual increase in construction inflation over the last three years to 4.50%.
Relevant Measures of Construction Inflation for Education and Healthcare Issuers
Certain related time series on the BLS website are directly usable by state and local entities and non-profit obligors, including New School Building Construction (NAICS 236222) and New Health Care Building Construction (NAICS 236224). The rate of change for each of the two time series is graphed below, on a trailing 12-month basis:
These two well-correlated measures tell a story that is consistent with the pattern for PPIFIS above: since a trough with some deflation in early 2024, inflation in the cost of building schools and hospitals has been building in the two years following July 2024, reaching 3.6% in June 2026. Cost inflation is on an upward trajectory, with the 12-month trailing average now exceeding AAA tax-exempt rates through 2038, making most forms of bridge financing lower in interest cost than anticipated cost inflation.
Relevant Measures of Construction Inflation for the Transportation Sector
A widely used proxy for the cost of general civil engineering projects nationwide, including tunnels, bridges and roads is the National Highway Construction Cost Index (NHCCI). The US DOT Federal Highway Administration publishes this on a quarterly basis, with the most recent data covering 4Q 2025. The rolling 4-quarter inflation average in this measure peaked at a higher level than the school and hospital time series; we have not yet seen renewed inflation in it. However, the trailing data posted in this measure does not provide us with insight into current inflationary conditions in the sector, so as of August 2026 it may be less useful than more recently published indicators. It does show a bottoming out of construction inflation during 2025. It will be instructive to see if data for the first and second quarters of 2026, once released, reflect a return to increasing inflation predicted in other measures.
The Capital Markets Context – Long-Term Financing Costs vs. Construction Inflation
Long-term tax-exempt financing rates as captured by 20-year AAA BVAL tax-exempt rates are a good proxy for the interest cost of debt structured with level debt payments over 30 years and an average maturity of 20 years. This measure has been trending upward since 2022, briefly peaking at 4.51% on April 9, 2025, a week after the announcement of broad-based tariffs on imported goods. On August 7, 2026, 20-year AAA BVAL closed at 3.97%, somewhat higher than the 3.6% school and hospital construction inflation rate but below the 5.5% inflation rate for PPIFIS and the 4.5% rate for TBCI. This likely makes long-term bonding ahead of planned and approved construction a prudent, efficient hedge for many issuers concerned about future construction costs but committed to necessary new construction and state-of-good-repair capital spending.
Medium to Intermediate Term Financing Costs vs. Construction Inflation
Issuers with variable rate capacity or the ability to treat large balloon payments of principal and mandatory tender bonds as being amortized on a level debt service basis over a long time horizon could have an additional compelling option given today’s steepened tax-exempt yield curve: mandatory tender and hard maturity balloon payment bonds in the 3 to 7 year maturity range. With 5-year AAA BVAL at 2.79% and 10-year AAA BVAL at 3.19% as of August 7, 2026, issuers have the opportunity to finance long-term projects ahead of future construction inflation at rates below today’s construction inflation rate. We estimate that it would require a 150 bp increase in rates as of a put date 5 years from now for a mandatory tender bond to break even with a 30-year level debt service transaction sold today, making a rolled mandatory tender bond a compelling alternative to long-term level debt.
Bond Proceeds: The Investment Context
Finally, the investment environment for bond proceeds that have not yet been spent is reasonably supportive for bonding ahead of future capital needs. Issuers could have the opportunity to invest in short-term taxable instruments in what futures markets currently anticipate will be a Fed tightening cycle. One-month T-Bills yielded 3.79% on August 7, 2026. If Fed Funds rise in line with market expectations, investment rates could be as high as 4.11% by June of 2027. Furthermore, if bond proceeds are spent at a rate that permits a spending exception to the arbitrage rebate rules, an issuer might be able to earn a yield in excess of the arbitrage yield on the bond issue itself.
Conclusion
A renewed round of construction inflation is a reality public finance issuers are living with after having absorbed what we now know was a permanent increase in price levels in the wake of the COVID-19 pandemic. While the rate of construction inflation is still below its 2022 peak it appears to be increasing and the uncertainty of how quickly this will play out creates an incentive for issuers to start capital projects sooner rather than later. At the same time, financing costs in the capital markets have increased, though with notable differentiation across a now steep tax-exempt yield curve where it is still possible for a high-grade issuer to borrow below 3% for 5 years. In our view, the inherent value of the tax exemption might give suitably-positioned issuers a significant incentive to borrow now and start construction as expeditiously as reasonably possible.
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