Inflation, price changes and real versus nominal analysis

Prices change over time. Construction materials, wages, energy and equipment generally become more expensive, while some technologies, such as solar panels, batteries and computing, have become cheaper. Engineering projects with lives of 20 years or more are strongly affected by these changes. Inflation also affects interest rates, the real value of tax deductions and the purchasing power of future revenues. This lesson explains how inflation is measured, the difference between real and nominal (actual) dollars, the relationship between real and nominal interest rates, how to perform consistent analyses in either real or nominal terms, differential price changes for specific items such as energy, the effect of inflation on after-tax analysis, and exchange rates for international projects.

Measuring inflation

Inflation is a general increase in the price level, which reduces the purchasing power of money. It is measured by price indices that track the cost of a representative basket of goods and services over time. The general inflation rate \(f\) between two years is the percentage change in the index; over several years, the average annual rate is the geometric mean:

In Canada, Statistics Canada publishes the Consumer Price Index (CPI) monthly, along with industrial product and raw materials price indices and building construction price indices for major cities. The Bank of Canada targets CPI inflation of 2 %, the midpoint of a 1 % to 3 % control range, under an agreement with the federal government that is renewed every five years.

Engineering cost estimates often use specialized indices rather than general consumer indices: construction cost indices, such as those published by statistical agencies and industry publications like Engineering News-Record; chemical plant cost indices for process industries; and equipment-specific producer price indices. These capture the price changes of the specific items in a project, which may differ markedly from general inflation.

Real and nominal dollars

Cash flows can be expressed in two ways. Nominal (actual, then-current) dollars are the amounts of money actually paid or received at the time, including the effect of inflation. Real (constant, today's) dollars express amounts in terms of the purchasing power of a base year. The two are related by the general inflation rate:

For example, $100,000 received in 10 years, with 2.5 % general inflation, has the purchasing power of about $78,120 today. Contracts, loans, tax rules and most financial data are expressed in nominal dollars; engineering estimates of future costs are often made more naturally in real dollars, for example "the plant will need 500,000 kWh a year at today's prices". Both are valid, but they must not be mixed.

Real and nominal interest rates

Market interest rates are nominal: they compensate lenders for both the real time value of money and expected inflation. The real interest rate \(i_r\) excludes inflation. The exact relationship, the Fisher equation, is:

For small rates, \(i_n \approx i_r + f\). With a real rate of 7 % and inflation of 2.5 %, the nominal rate is \(1.07 \times 1.025 - 1 = 9.675\,\%\). Firms often state their MARR in nominal terms because their financing costs are nominal; public agencies often specify real discount rates for benefit-cost analysis (Lesson 8). Real and nominal MARRs must be converted with the Fisher equation, not by subtraction alone, when precision matters.

Consistent analysis

The golden rule of inflation in engineering economics is consistency: either discount real cash flows at a real interest rate, or discount nominal cash flows at a nominal interest rate. Both approaches give the same present worth when done correctly, because each nominal cash flow is the real amount inflated at \(f\), and the nominal discount factor includes the same inflation.

Common errors are discounting real cash flows at a nominal rate, which undervalues future benefits and biases decisions against long-lived investments, and discounting nominal cash flows at a real rate, which overvalues them. Spreadsheets should label every column and rate as real or nominal.

Differential price changes

Not all prices change at the general inflation rate. Energy, labour, materials and technologies have their own price trajectories, and the difference matters for engineering decisions. If electricity prices are expected to rise 2 % a year faster than general inflation, an efficiency investment's real savings grow at about 2 % a year, which can be modelled as a geometric gradient in real terms (Lesson 3). Conversely, if a technology's cost is falling, delaying a purchase may be worth considering. The real escalation rate \(e_r\) of a specific item relates to its nominal escalation \(e_n\) and general inflation \(f\) by \(1 + e_n = (1 + e_r)(1 + f)\). Energy price forecasts from government agencies and utilities, and long-term construction cost trends, are common sources for differential escalation rates, and because they are uncertain, sensitivity analysis is essential.

Inflation and taxes

Inflation interacts with taxes because tax depreciation is based on historical (nominal) cost and is not indexed to inflation. As inflation rises, the real value of depreciation deductions falls, while revenues and costs rise with prices, so taxable income and taxes rise in real terms. The result is that inflation reduces the after-tax real return on capital investments. After-tax analysis with inflation must therefore use nominal cash flows (or carefully deflated ones), with depreciation fixed in nominal dollars.

Similar effects apply to fixed-rate loans, which become cheaper in real terms during inflation (benefiting borrowers), and to contracts with fixed prices, which shift risk between parties. Escalation clauses in long-term contracts adjust prices by agreed indices to share inflation risk.

Inflation and project financing

Inflation affects the cost of financing and the cash flows of long-term contracts. Infrastructure projects funded by long-term fixed-rate bonds benefit from inflation in real terms, while revenues from user fees may be indexed to inflation under concession agreements. Engineers working on public-private partnerships and long-term operating contracts should understand how revenues, costs and payments are indexed, because mismatches between indexed revenues and unindexed costs, or the reverse, can transform a project's economics.

Exchange rates

International projects add another source of price change: exchange rates. Equipment bought from abroad, revenues earned in another currency and loans in foreign currencies expose projects to exchange rate risk. Analysts can work in one currency, converting forecast foreign cash flows at expected exchange rates, or analyse in each currency and convert present worths. Purchasing power parity suggests that, over the long run, exchange rates move to offset inflation differences between countries, but in the short and medium term exchange rates are volatile. Hedging with forward contracts, matching currencies of costs and revenues, and sensitivity analysis manage the risk. For projects between Canada and the United States, the Canadian–US dollar exchange rate can change project economics significantly, especially for imported equipment.

Here \(X_t\) is the expected exchange rate in units of home currency per unit of foreign currency in year \(t\).

Inflation in construction contracts and estimates

Long construction projects face inflation between estimate and completion. Estimators escalate costs to the midpoint of construction using forecasts of construction cost indices, and owners include escalation allowances in budgets. Contracts allocate inflation risk: lump-sum fixed-price contracts place it on the contractor, who prices it into the bid; contracts with price adjustment clauses tied to indices for steel, fuel, asphalt or labour share it; and cost-reimbursable contracts leave it with the owner. In periods of rapid inflation, as in 2021 to 2023 when construction material prices rose sharply in both countries, contracts without adjustment mechanisms led to disputes and losses, prompting many public owners to add index-based price adjustment clauses for volatile materials.

Inflation forecasts and sensitivity

Long-term inflation forecasts are uncertain. Central bank targets of about 2 % provide a reasonable base case for general inflation in both countries, but actual inflation has deviated substantially, as the period from 2021 to 2023 showed. Analyses of long-lived projects should test sensitivity to higher and lower inflation, particularly for after-tax analyses, for projects with fixed-price revenue contracts, and for projects financed with fixed-rate debt, where inflation shifts value between parties. Real analysis is often preferred for long-term public projects precisely because it avoids the need to forecast general inflation, focusing instead on relative price changes such as energy prices compared with general prices.

Indexing and real wages

Labour is a major cost in many projects, and wages often rise faster than general inflation as productivity grows. In real analysis, labour costs may therefore be escalated at a real rate of perhaps 0.5 % to 1.5 % a year, increasing the attractiveness of automation and labour-saving investments over time. Collective agreements with scheduled wage increases provide specific nominal escalation for unionized workforces.

Deflating historical cash flows

Post-audits and benchmarking compare past project costs, which were recorded in nominal dollars of different years. To compare them fairly, convert each to constant dollars of a common base year by dividing by the ratio of the price index in its year to the index in the base year. Using a construction-specific index rather than the CPI gives better comparisons for construction costs, because construction prices can diverge from general consumer prices for long periods.

Whichever approach is chosen, the report should state clearly whether figures are in real or nominal dollars, the base year for real dollars, and the inflation and escalation rates assumed for each category of cost and revenue.