The uncertainty of inflation and its impact on federal spending

There is some truth in saying that the usual measurements for gauging how global economies are performing and trending still have meaning, but have gotten increasingly disconnected from each other.

A recession may feel like a certainty but how and when one would unfold seems anybody's guess at the moment, including the Federal Reserve as it moves forward on interest rate increases.

One important fact to consider is that when a recession occurs, its magnitude is only known in retrospect, according to a macroeconomic and budget presentation Wednesday at the Professional Services Council’s annual Vision Forecast conference.

The National Bureau of Economic Research has that responsibility for making that declaration. But it can only look back and say "yes, we were" in a recession versus saying so in real-time, said PSC Vision Volunteer and session presenter Lou Crenshaw.

Sustained weak growth or a decline in gross domestic product, typically over two consecutive quarters, is a headline-grabbing indicator that shows when a recession occurs.

Here are some of the others: a spike in unemployment, slowdowns in manufacturing activity, drops in personal incomes and an inversion in the yield curve. The latter measures the returns on bonds and other debt that trades in the public markets.

Unemployment and job openings directly apply to the government market given how talent tops the agenda of substantially for all companies in the market.

As Crenshaw put it, the data tells him and the PSC vision team that the overall labor participation rate remains below what it was before the COVID-19 pandemic started.

Job numbers lead to the Federal Reserve's big question as it continues to hike interest rates. Crenshaw said that question is whether it can raise the rates in a manner that does not go too high or too fast and bring forward a recession.

"Can they (the Fed) reduce the number of job openings without significantly affecting the unemployment?," Crenshaw asked rhetorically. "Because that's the whole name of the game, that's what they're after."

Then there is the matter of inflation, which every company in all industries has to deal with: even ones with a steady reliable billpayer such as the federal government.

Inflation remains rampant throughout the world and hit a four-decade high of 8% this year. While many prices have come down in recent months, Crenshaw said energy costs remain somewhat elevated even though those have also trended lower.

Rate hikes that are just enough to result in moderate GDP growth of 2%-to-3% and a modest rise in unemployment to around 4% is the economy's best case scenario that Crenshaw called a "Soft Landing."

Scenarios two and three that Crenshaw laid out are much more precarious for the economy.

A "Hard Landing" would happen if the Fed raises rates too quickly or too high, which translates to wages and prices spiraling upward.

Potential outcome three is stagflation and that is also bad. Under that scenario, interest rates go up too high and companies respond with layoffs. High inflation remains in place and economic growth stalls.

What does that all mean for future federal budgets, and particularly for the Defense Department?

"We still don't link defense spending and the economy in my humble opinion," Crenshaw said.

The conflict in Ukraine and DOD's support of their defense is one big factor that has changed the conversation around defense spending. So has inflation, but how DOD and civilian agencies have come to terms with it has not shown up in budgets.

As Crenshaw pointed out, one big problem for federal agencies is that life under a series of stopgap continuing resolutions does not keep pace with the rate of inflation.

"When we have a CR and we're only able to spend the same amount of money that we had last year, we effectively have reduced our buying power by 15%," Crenshaw said. "The effects of inflation are really eating into our ability to buy things in DOD."