The $773 billion question: Inflation’s impact on defense spending

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The US Department of Defense (DoD) has not had to worry about significant inflation since 1983. While decision makers in the Pentagon and other organizations have dealt with occasional spikes in commodity prices, especially for oil, the prospect of rapid, across-the-board price increases has not been a concern, because annual inflation has averaged about 2.5 percent for the past several decades.1

In the past year, however, the situation has shifted: the annual inflation rate hit 7 percent at the end of 2021—the highest level since 1982.2 While most economists expect inflation to moderate, some are increasingly concerned that prices will continue to rise in the near term.3 Indeed, the consumer price index (CPI) rose by 7.9 percent through February 20224 and the Federal Reserve anticipates that the inflation rate for the personal-consumption expenditures price index will be 4.3 percent by the end of 2022, a 65 percent increase over its December 2021 projection of 2.6 percent.5

Compounding this problem for the DoD, prices for the goods that it typically purchases tend to rise at a rate higher than the CPI. For example, during 13 of the 22 fiscal years from 2000 through 2021, year-on-year defense inflation exceeded the CPI for urban wage earners and clerical workers (CPI-W).6 On average, defense inflation was 20 basis points above this index.7

Because defense has historically experienced higher inflation than other economic sectors in the United States,8 industry leaders and Pentagon programmers might benefit from a greater focus on productivity gains as a means for cost containment.

Our modeling indicates that the DoD could lose over $100 billion in purchasing power within five years if the economy reenters a period of high inflation and low nominal topline increases in the defense budget, similar to what happened in the 1970s. In that scenario, the DoD would have limited funds to invest in modernizing military equipment, especially since the department would still have to increase military pay to meet mandatory requirements. At times, moreover, the department may have to operate under a continuing resolution, which limits spending to the amount approved in the previous year. As a result, industry stakeholders will increasingly need to focus on improving productivity throughout a defense program’s life cycle.

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High inflation and low nominal topline defense budget increases have a compound effect over time

For years, the Pentagon and the Office of Management and Budget (OMB) have assumed an annual inflation rate of about 2 percent.9 Although the DoD did not publish a Future Years Defense Plan (FYDP) in its budget for fiscal year 2022, past planning assumed that the current rate of inflation would remain at around the same level. The Congressional Budget Office (CBO) also assumed 2 percent inflation in its assessment of budget growth over the next ten years.10 With the recent rise in prices, the OMB is reportedly planning to adjust its assumption to 4 percent inflation in FY 2023.11 The CBO, meanwhile, has updated its 2021 projection to accommodate 5.4 percent inflation in 2022 before returning to just above 2 percent by the middle of the decade.12 At the moment, however, it seems that these figures may underestimate long-term inflation—and this could have a huge and compounding effect on the DoD’s buying power.

Since much uncertainty about inflationary trends persists, we created several scenarios to show how the DoD’s buying power might change over the next five years (Exhibit 1). For this analysis, we excluded military construction and thus used the following figures:

Inflation will influence the buying power of the Department of Defense for the $773 billion budget approved for fiscal year 2023.

Assuming the expected rate of increase, the budget would rise from $755 billion in fiscal year 2023 to $810 billion in fiscal year 2026.

Under the CBO’s earlier estimate of approximately 2 percent inflation annually, DoD could have a buying power of $732 billion in 2026 (in 2021 dollars)—a slight real increase over the fiscal year 2022 budget. If we assume that the CBO’s updated inflation forecast of 5.4 percent is accurate, the DOD could have $692 billion in buying power in 2026. But if the inflation rate stays at 7 percent per year as it did during part of 2021, and if there are no additional increases in future budget requests, the DoD’s buying power drops to $578 billion—a difference of 21 percent from the $732 billion in buying power that it would have if inflation was about 2 percent. The cumulative loss of buying power from 2021 to 2026 could be some $480 billion, which is equivalent to the cost of about 6,000 F-35 fighter jets or 160,000 Patriot missiles.

In a worst-case scenario—high inflation and no offsetting defense budget increases, similar to what happened in the United States from 1973 to 1982— the DoD’s buying power would fall to $543 billion in real terms by 2026.15

Increased military personnel costs could further crimp investment

As Exhibit 2 shows, both civilian and military pay increased by more than the CPI from 1973 through 2021. High inflation cuts consumer spending power and often prompts employers to increase salaries to remain competitive, suggesting that pay might increase at an even higher rate in the future. Within the DoD, the desire to retain people, particularly on the military side, could add significantly to wages.

Pay for military personnel and civilian defense personnel tends to rise more sharply than the consumer price index.

Military-pay increases—for example, a 2.7 percent raise on January 1, 2022—have generally enjoyed bipartisan support in Congress.16 We expect any future increases to be closely tied to the Employment Cost Index (ECI),17 which at 4.6 percent18 is now higher than the DoD’s reported rate of increase in pay. Higher wages will put even more pressure on the DoD’s operations and investment accounts than they have in the past few years. If higher inflation persists through 2026, continued wage growth of 4.6 percent annually would account for $45 billion more of the topline defense budget than what was anticipated in the projected budget from fiscal year 2022 through 2026 (Exhibit 3).19

If wages are adjusted for higher inflation, the additional personnel costs will reduce the amount of money available for investment and operations.
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Better costs and productivity on the supplier side

Defense companies have no influence over inflation rates or future defense budgets but can take critical steps to help the DoD maintain its buying power. In fact, such steps may be essential to helping the DoD achieve its goals.

First, suppliers may gain an edge though a new cost-reduction approach that sets market-backed targets across all areas—external spending, internal manufacturing, functional support for programs, and indirect costs—throughout the entire program lifecycle. When we assessed productivity within major defense acquisition programs, we found that this approach conveyed many benefits.

Defense companies may also want to consider creating cost control towers, which are common in other industries, early on, during the program phases that involve low-rate initial production and the full-rate production. By setting functional targets and rigorously tracking progress against the baselines of programs, cost control towers empower junior employees to drive cost reduction initiatives and bring functional leaders together to unlock cross-cutting ideas that could improve productivity. Cost control towers can also help companies remain on a stable footing and preserve margins above commitments, even as customers request lower prices to counteract the erosion of buying power.

Defense companies have no influence over inflation rates or future defense budgets but can take critical steps to help the DoD maintain its buying power.

Finally, defense companies may improve their margins and control their costs by focusing on productivity from a program’s outset. Even as bids are being developed, these companies can look for opportunities to take work out of the system. Further, they may boost their productivity by using digital tools to improve internal and customer reporting. In addition to accelerating processes and reducing the amount of manual work required, these tools help set programs on the path to affordability. Industry 4.0 digital-engineering technologies, such as simulated prototyping, can significantly reduce spending on upfront development. Furthermore, since most spending by manufacturing OEMs occurs in the supply chain, the use of advanced analytics for spending analyses and risk assessments for upstream suppliers can also help drive down costs.20The CEO agenda for companies in advanced industries,” McKinsey, February 2, 2021; Kevin Goering, Yogesh Malik, Victoria Potter, and Kevin Sachs, “Industrial ‘lighthouses’ for tech-enabled transformations,” McKinsey, January 31, 2020; and Francisco Betti, Enno de Boer, and Yves Giraud, “Industry’s fast-mover advantage: Enterprise value from digital factories,” McKinsey, January 10, 2020.

Events in Ukraine, economic conditions, and other developments around the globe may change the trajectory of the fiscal year 2023 President’s Budget Request (PBR) and congressional appropriations. But even with nominal increases in the budget, higher-than-historical inflation will be a challenge that requires focused attention from DoD and defense industry leaders.

In addition to exacerbating budget pressures and complicating hiring and retention within the DoD, price increases could create financial problems for many private companies at all levels of the value chain. Suppliers may be unable to find materials and components at an affordable price, for example, and that could force the renegotiation of contracts and negatively affect company financials. Price inflation could also add to existing supply chain difficulties by forcing companies to pay more to ensure the availability of critical components, such as semiconductors.21

To address these risks, the DoD and industry leaders might try dusting off the lessons of the last inflationary period and consider taking steps to increase affordability, improve inventory management, and develop better contracts that will help both buyers and sellers if costs rise.

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