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The $773 billion question: Inflation’s

impact on defense spending

March 28, 2022
| Article

How will the Defense Department deal with possible long-term

inflation and price increases for its most important programs?

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Article (7 pages)

T
he 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 2022[ 4 ]
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.

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:

for fiscal year 2022, a $729 billion budget as specified in the latest omnibus bill

passed by the House[ 13 ]

for fiscal year 2023, a $755 billion budget reflecting the anticipated requested

budget of $773 billion minus estimated military construction[ 14 ]

Exhibit 1

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.
Exhibit 2

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 percent[ 18 ]
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 ]
Exhibit 3

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.[ 20 ]
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.
1.
Defined as the average year-on-year increase in the consumer price index for urban wage earners
and clerical workers (CPI-W). This is the value cited as an inflation measure by the Department of
Defense in National Defense Budget Estimates for FY2022, colloquially known as the “green book.”
2.
Neil Irwin, “Inflation hits 7% in December, highest since 1982,” Axios, January 12, 2022.
3.
For example, see Jason Furman, “Four reasons to keep worrying about inflation,” Wall Street
Journal, January 13, 2022.
4.
Martha C. White, “Inflation up 7.9 percent in February compared to last year as price rises grip
U.S. economy,” NBC News, March 10, 2022.
5.
“Summary of Economic Projects,” The United States Federal Reserve, March 16, 2022.
6.
CPI-W is the value cited as an inflation measure by the Department of Defense in National
Defense Budget Estimates for FY2022.
7.
Values derived from National Defense Budget Estimates for FY2022, “Table 5-1—Department of
Defense and selected economy-wide indices.”
8.
The reasons may include the impact of fuel costs on the military; the differing baskets of goods
and services consumed by the DoD, on the one hand, and typical consumers, on the other; and the
cascading impact of inflation across the defense value chain, which affects final program costs.
9.
As cited by the Office of Management and Budget, Analytical Perspective: Budget of the U.S.
Government Fiscal Year 2022 (2021).
10.
Congressional Budget Office, Additional Information About the Updated Budget and Economic
Outlook: 2021 to 2031 (2021).
11.
Tony Capaccio, “Pentagon gets its target budget number from White House Office,” Bloomberg,
February 16, 2022.
12.
Phillip L. Swagel, “Re: Budgetary effects of higher inflation and interest rates,” letter to Senator
Mike Crapo, March 2, 2022.
13.
Sam LaGrone, “Last minute FY 22 $728.5B defense bill funds 13 Navy ships, 12 F/A-18s; saves 3
LCS from decommissioning,” USNI News, March 9, 2022.
14.
Anthony Capaccio and Roxana Tiron, “White House to seek $813.3 billion national security
budget,” Bloomberg, March 23, 2022.
15.
According to the green book, the CPI-W grew at about 8.3 percent annually from 1973 to 1978.
Over the same period, according to the OMB, spending on Function 050 (National Defense) grew by
6.4 percent annually. National Defense Budget Estimates for FY2022, “Table 5-1—Department of
Defense and selected economy-wide indices”; and Office of Management and Budget, “Table 3.2—
Outlays by function and subfunction: 1962–2026.”
16.
Leo Shane III, “New in 2022: A coming debate over military pay could lead to troops’ biggest
raise in 20 years,” Military Times, January 4, 2022.
17.
The Employment Cost Index is a quarterly economic series, published by the Bureau of Labor
Statistics, that details the growth of total employee compensation.
18.
Leo Shane III, “New in 2022: A coming debate over military pay could lead to troops’ biggest
raise in 20 years,” Military Times, January 4, 2022.
19.
This analysis assumes that the 4.6 percent growth of the ECI would mean a corresponding
increase in overall DoD personnel spending. It also assumes that the share of DoD spending on
personnel would be the same as the share in the projected total for fiscal years 2022 through 2026.
The extra spending represents what is required, on top of the anticipated share, to match the 4.6
percent growth in military pay for personnel.
20.
For examples of these types of technologies, consult Thomas Baumgartner, Rajat Dhawan, and
Asutosh Padhi, “The 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.
21.
On the availability issues that already exist, see, for example, “Results for semiconductor supply
chain request for information,” US Department of Commerce, January 25, 2022.
 ABOUT THE AUTHOR(S)
Peter Bacon is a knowledge specialist in McKinsey’s Washington, DC, office,
where Eric Chewning is a partner and Jess Harrington is a solution associate.
Chris Daehnick is a solution associate partner in the Denver office, and
Nikola Popovic is a data engineer in the Atlanta office.

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