This month, as Congress starts crafting the fiscal 2023 Defense Department budget, policymakers must decide how to deal with inflation’s erosion of the Pentagon’s purchasing power. A growing number of legislators have called for increasing the budget above the Biden administration’s $773 billion request to compensate for high inflation, among other rationales. Many policymakers have shied away from proposing dollar amounts, instead endorsing specific levels of real growth — the year-to-year percentage change in spending after accounting for inflation, such that 0% means spending grows at the forecast inflation rate.
The trouble is that when inflation is changing quickly, like today, real growth resembles Potter Stewart’s definition of obscenity: “I know it when I see it.”
During periods with volatile inflation, policymakers have different outlooks on the accuracy of the inflation forecast. As a result, they also have different standards for what qualifies as “real” growth. To make sound judgments about the FY23 budget, policymakers need to consider not only their preferences about real growth but also their beliefs about future inflation. Combining a little history and a little math illustrates the wide-ranging options available to Congress as it sets this year’s defense budget.
The FY23 Pentagon budget request assumed inflation would average 2.2% in 2023. This rate represents the gross domestic product price index that anchors Defense Department budget planning, as mandated by the Office of Management and Budget. Critics have cited alternative indices reporting higher rates, such as the consumer price index, to suggest that the assumed inflation rate is potentially too low. As a practical matter, the GDP price index should continue to anchor budget planning because it performs well relative to alternatives, according to technical studies.
All the attention paid to alternative indices has distracted from a vitally important question: How accurate have GDP price index forecasts been in the past?
By surveying the range of prediction error in previous forecasts — specifically forecasts looking one year ahead — we can benchmark the range of potential error in the current forecast. This benchmark could prove inaccurate if something unprecedented happened with inflation. However, including periods with extreme inflation outcomes, such as the late 1970s, lowers that risk.
From 1977 to 2020, the period for which data exists in Defense Department reference volumes, forecasts looking one year ahead predicted the GDP price index inflation rate reasonably well. The U.S. government overestimated inflation (meaning the forecast exceeded the rate) more often than it underestimated inflation, with 24 overestimates, 16 underestimates and four bull’s-eyes. The maximum underestimate forecast the inflation rate 2.5 percentage points too low (1979), whereas the maximum overestimate forecast the inflation rate 2 percentage points too high (1986).
These historical outcomes illustrate how policymakers might, depending on their outlook on future inflation, adjust the FY23 budget. For example, policymakers deeply concerned that the assumed 2023 inflation rate of 2.2% is too low might consider increasing the budget by an additional 2.5 percentage points, matching the maximum underestimate from 1979. That adjustment would produce a $792 billion budget, representing 0% real growth with our higher assumed inflation rate. Policymakers could then increase spending further, if desired, based on their real growth preferences. In this scenario, 5% real growth would yield a $830 billion budget, nearly $60 billion above the request.
Policymakers skeptical about this worst-case thinking might instead consider increasing the budget by an additional 0.3 percentage points, a less extreme key value from the historical data that falls closer to the official forecast. That adjustment would result in a $776 billion budget, again representing 0% real growth with our assumed inflation rate. In this alternative scenario, 5% real growth would produce a $814 billion budget, an increase of $41 billion above the request that falls exactly halfway in between the increases recommended by the Senate and House Armed Services committees in June.
In weighing these options, policymakers should remember that inflation factors are not the only way to judge the budget’s sufficiency. Equally important is the question of how the U.S. forces supported by the budget would fare against enemy forces in likely conflict scenarios. If we believe that the forces and budget provide roughly the right level of defense, then estimating inflation’s deleterious effects matters greatly. By contrast, if we believe that the forces and budget do not provide the right defense, then devoting disproportionate attention to inflation distracts from larger problems.
In sum, inflation can, alongside other factors, rightfully inform judgments about the appropriate level of defense spending.
Real growth alone does not provide an adequate standard for setting defense spending given today’s uncertainty about tomorrow’s inflation. Specific real-growth percentages can yield different budgets depending on one’s outlook on future inflation. For this reason, legislators need to define, even if privately, the inflationary losses in defense buying power that they seek to avoid or accept in the FY23 budget. The illustrative options above provide one way to think about this central issue.
Travis Sharp is a fellow and the director of defense budget studies at the Center for Strategic and Budgetary Assessments. This commentary is adapted from his forthcoming CSBA report, “How I Learned to Start Worrying and Hate Real Growth: Analysis of the 2023 Defense Budget Request.”