Takeaway: Appropriators have produced a draft 2018 Defense bill but the numbers still don't add up. A deal will happen but not until after Christmas.

Prior to its Thanksgiving recess the Senate Appropriations Committee finally released its draft of the 2018 Defense appropriation bill.  The Committee proposes to give the Pentagon $660B in new budget authority: $590B in the baseline and an additional $70B in OCO and emergency spending authority.  This would be an 8.9% y/y increase over 2017.  

The Senate draft is more generous than the President's request for $644B ($574B+$70B) and slightly lower than the recently passed National Defense Authorization Act's (NDAA) $671B ($611B+$60B). While the SAC mark is usually the definitive milestone in the annual budget development process, that is not the case this year as it is still $68B greater than allowed by the Budget Control Act (BCA).  The BCA caps are what matter. 

Budget End Game Approaches: Resetting the Board - Screen Shot 2017 11 25 at 10.09.03 PM

Despite the amount of energy going into tax reform legislation, investigations, etc, etc, talks among Congressional leaders about raising the BCA caps for 2018 and 2019 have occurred.  This would be a third consecutive two-year amendment to the 2011 Budget Control Act.

  • While there is a cohort of Republicans opposed to any change to the caps or at most increasing only the defense cap, Republican leaders who want to get something done have floated the idea of increasing the overall discretionary caps by $180B over two years with the defense cap being raised by ~$54B and the non-defense cap by ~$36B for each of the two years.  This would put defense spending at approximately the President's request for 2018 and what he has forecasted he will request for 2019. 
  • Per formula, Democrats want parity in the raising of the defense and non-defense caps.  This would mean either accepting something less than the President's request or increasing the overall level of discretionary spending even more than ~$90B/year. 
  • A substantial deal that is only good for two years sets up the President and Congress in 2019 with the threat of a large cut in spending back to the BCA levels in 2020 - a Presidential election year.

OUR CALL: Congress will raise the defense BCA cap by at least $28B but no more than $54B. A deal that is low on the baseline side, will result in an inflated OCO number. Expect final total Pentagon spending to be about $645B = ~+6% y/y.

Meanwhile, the clock is ticking. The Continuing Resolution that is keeping the government operating at the 2017 level of spending expires on December 8.  Even if some sort of topline agreement on the caps can be agreed in the next week or so, it will still take 3-4 weeks to align and pass the appropriations bills with that agreement, implying the need for an extension until at least the end of the year. Expect a short extension.

A long extension (beyond early January) of FY17 funding levels is injurious to the Pentagon which has larger endstrengths in 2018 than 2017, higher operational tempo in AFG and the Pacific in 2018 than 2017 and legal prohibitions on program changes, e.g., new ship starts. Further, since the FY17 level of defense spending is actually about $2B higher than the legal cap for 2018, sequestration could kick in automatically in early January to actually lower baseline spending levels by $2B just as the Pentagon and defense industry are counting on an increase of ~$54B.