Will Inflation Impact Defense Spending?

At the end of 2021, the annual inflation rate hit 7%—the highest level the U.S. has seen since 1982. Despite previous statements describing inflation as “transitory,” the consumer price index (CPI) rose by 7.9% through February 2022, and the Federal Reserve predicts that the inflation rate for the personal consumption expenditures (PCE) price index will increase 65% by the end of 2022. The earnings of many working Americans are failing to keep pace with inflation, and the federal government is beginning to feel similar pressure as it faces rapid, across-the-board price increases. A recent report by McKinsey & Company predicts that the Department of Defense (DoD) in particular will experience significant pain in the near term.

With the FY2023 defense budget sitting at $773 billion, it would seem that there is plenty of room to accommodate rising prices and wages. However, defense has historically been a higher inflation sector than others in the U.S., and McKinsey’s modeling suggests that the DoD could lose over $100 billion in purchasing power within five years if high inflation and low budget increases continue. Such a scenario would see the DoD receive limited funds to invest in modernization efforts, but still be obligated to increase military pay to meet mandatory requirements.

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The report further suggests that a combination of high inflation and low nominal topline defense budget increases have a compounding effect over time, with current Congressional Budget Office (CBO) assessment figures assuming 2% inflation in budget growth over the next ten years. Ultimately, by underestimating long-term inflation, the DoD will find its purchasing power reduced.

These factors ultimately leave defense contractors in a position where they must take crucial steps to help the DoD maintain its buying power. The report suggests that suppliers could gain an edge by setting market-backed targets across all areas throughout an entire program’s lifecycles. Defense companies could also benefit by creating cost control towers and setting functional targets while tracking progress to enable junior employees to drive cost-reduction and unlock cross-cutting productivity ideas, while preserving margins.

Ultimately, while defense contractors cannot control inflation and have little means of limiting wages in an employee-focused hiring market, they can maintain profitability and ensure the most “bang for the buck” by focusing on productivity and data-driven decision-making. Given that the U.S. spends more on its military than the other nine top-spending nations combined, there is a lot at stake for companies who fulfill government contracts.