Given the complexity and longer time horizon of many of these capital programs, local and state governments generally allocate set funding with an inflation factor, including the infrastructure programs funding through the federal government. However, with the current inflation numbers, the public sector may be faced with the dilemma to either scale back on the scope of these projects or find alternative funding sources.

A recent report by S&P ratings on inflation and local government capital programs indicates that the current high levels of construction costs couldn’t have arrived at a more inopportune time. With historic levels of federal investment in infrastructure starting to flow, cost inflation is beginning to erode some of its benefits. The report also states that “In addition, the producer price index (PPI) for building materials and supplies increased around 25% between March 2021 and March 2022 and around 60% from January 2020.”

In this article, we will take a closer look at how local and state governments will likely deal with the ongoing inflation challenges and funding their planned capital projects.

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When looking at any small to large infrastructure project for local governments, it’s driven by an overall cost estimate that typically entails many of the known contingencies and variables: time delays, inflation, supply chain issues, labor shortages, etc. The difference is that in current times, many of these known contingencies have come true, all at the same time, and project timelines are faced with adverse impacts.

In this situation, depending on the funding for the project, many of the project sponsors—local and state governments—are grappling with tough decisions about the future of these capital infrastructure projects. Some of these decision include:

• Whether the federal funding will be enough to see the project to fruition

• What components of the project can be cut or delayed with the ongoing economic challenges, if needed

• What other funding sources can be tapped to supplement the pre-planned funding sources in the current times

The inception of the aforementioned challenges started with COVID-19, as countries halted their economic activity to control the spread of the virus. Current supply chain issues are a by-product of the manufacturing sector being shut around the world for a significant period and the attempts to revive the sector to pre-pandemic levels. It’s safe to say it hasn’t been easy for the global economy. In addition, the rise in prices for goods and services also started around the same time, which persisted and grew to current levels. One of the leading indices in this realm is Producer Price Index, which takes into account the average change in the prices that a manufacturer/producer receives in the U.S. for producing/selling goods and services. As mentioned at the beginning, this index has witnessed some historic rises in the last few years, including a 25% increase from 2021 to 2022; and a 60% increase from 2020 to 2022.

As the cost for goods and services remains at historic highs, it’s inevitable for local governments to see higher overall project costs, including possible amendments to the already executed construction contracts to include equitable compensation due to price increases. Along the same lines, S&P rating assesses the outcome as, “that construction cost inflation will result in public sector project sponsors seeing higher bids from contractors, larger contingencies in new contracts along with wider cost escalation ranges for materials, plus a shift away from fixed-price contracts. Public project sponsors could also receive claims for equitable adjustment for compensation by contractors on existing projects or experience higher bids for follow-on work to recoup previous losses.”

Furthermore, there is also geopolitical uncertainty in Eastern Europe that’s fueling the fire. With the current U.S. sanctions, local and state governments are also having to review and evaluate all their current contracts and vendors to ensure they are compliant with the U.S. government’s sanctions on Russia.

Local and state governments may have already started these capital projects with funding provided through the infrastructure bill; however, the pre-planning and originally allocated funding may not be enough. This means that governments will either have to look for their own funding source or delay/cut the project scope, which also means that unless governments have additional funding to spare and allocate toward these funding deficiencies, the only solution is to access the capital markets to raise the needed capital. And, with the Fed’s aggressive interest rate hikes, the cost of raising capital has gone up.

Furthermore, the aforementioned uncertainties and challenges will likely not go away overnight. Economists are warning that all leading economic indicators are hinting toward a possible recession, which can present its own challenges in terms of hitting local and state governments’ revenue sources.

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With the recent infrastructure push, investors were already seeing momentum in local governments issuing municipal debt to finance their capital projects. However, with the recent rate hikes by the Federal Open Market Committee (FOMC) to tame inflation, accessing the capital market has become pricier for issuers. It almost seems that the combination of inflation and timing of infrastructure spending couldn’t have been more challenging for local governments. Time will tell how municipalities navigate these challenging times and keep the momentum going with their infrastructure projects.

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Disclaimer: The opinions and statements expressed in this article are for informational purposes only and are not intended to provide investment advice or guidance in any way and do not represent a solicitation to buy, sell or hold any of the securities mentioned. Opinions and statements expressed reflect only the view or judgement of the author(s) at the time of publication and are subject to change without notice. Information has been derived from sources deemed to be reliable, the reliability of which is not guaranteed. Readers are encouraged to obtain official statements and other disclosure documents on their own and/or to consult with their own investment professionals and advisers prior to making any investment decisions.