Defense spending is fueling growth but poses a risk to inflation

Monthly new orders for defense capital goods increased to $22 billion in April, with the 12-month sum of $215 billion 27% higher than a year earlier.

That growth rate is likely to increase as the months with lower spending in early 2025 drop out of the yearly calculation.

The shot in the arm for manufacturing is already boosting gross domestic product and the labor market, where 25,000 new manufacturing jobs have been added in the first five months of the year.

At the same time, however, additional defense spending will be pressuring inflation higher, with increased demand for goods most likely outpacing supply.

The Iran war has resulted in a special supplemental request of $87.6 billion to support replenishment of the U.S. weapons stock.

But it won’t end there. The Pentagon will need more money to support a build-out of the emerging drone and robotics technologies and the associated supply chains.

In the end, the special supplemental measure is likely to exceed $100 billion, which will provide a tailwind to GDP.

Capital goods include small arms and ordnance; communications equipment; aircraft; missiles, space vehicles and parts; ships and boats; and search and navigation equipment, not to mention everything that goes into the supply chains that support them.

Because of the demand for similar goods used at earlier stages of production by both the defense and tech sectors, scarce resources will presumably become more expensive—and by year-end the conversation will shift from guns versus butter to guns and butter, with both stoking inflation.

Budgetary considerations

According to the Congressional Budget Office, the Defense Department’s fiscal year budget request totaled $961 billion, including $113 billion provided by the 2025 Budget Reconciliation Act.

Most of the reconciliation funding would be allocated to acquisition. 

When adjusted for inflation, the budget request was one of the largest in 50 years, the CBO found.

Is this a one-time allocation? The CBO said the defense budget could be interpreted in three ways:

1. As a one-year increase
2. As a short-term increase to modernize forces, similar to the Cold War buildup in the 1980s
3. As a permanent increase to keep pace with the enduring cost of defense

Without sufficient guidance, the CBO chose to consider the overall budget as a one-time request.

In our evaluation, the need to replenish supplies and develop new capabilities like drones and robotics will result in higher defense spending.

The government’s investment in private defense contractors is already having an impact on the labor market, which will translate into greater household spending, adding to GDP growth.

But if that government spending goes unfunded, there needs to be consideration for the squeezing out of other investments that are essential for sustained growth.

The lessons of other periods of increased military spending are that while defense spending is necessary, it does not automatically translate into longer-term growth and can cause inflation