Will (Should) Short-term Inflation Increase Pay Levels?

One of the most important principles underlying sound compensation management is that the cost of labor, not the cost of living, should impact how organizations pay their people.  Inflation is a macro-economic measure that is impacted by factors outside the control of organizations.  The ability of a firm to compete effectively for the talent it requires will be impacted by what others competing for that talent offer. The cost of labor often varies from the cost of living in labor markets… a shortage of a skill set can drive up the cost of labor for that skill significantly, even if the local cost of living is low.  This necessitates the responses by employers that are based on the cost of labor in the relevant markets, not the cost of living.

Economists vary widely in their predictions about future inflation.  Some believe the current rate of short-term inflation has been the result of the pandemic and that it will subside as things return to a more normal state.  But someone who has to pay the rent or mortgage or fill the gas tank does not explore the causes of the higher prices and feels that their real purchasing power has declined.  The result is pressure by workers to reinstate their pre-pandemic standard of living and to do so with pay increases that are at least as large as the rate of short-term inflation (or what it is perceived to be).

The cost of an existing workforce is largely fixed. Base pay (salaries or wages) only go up, since workers expect they can maintain their standard of living based on the pay and benefits they currently have. They typically believe their employer has committed itself to those levels, through a social (if not legal) contract. Although they might accept a temporary cessation of increases to their rewards package because their employers are suffering significant revenue declines, they are likely to believe they are owed a level of real income that increases (or at the worst, temporarily stays the same).  Reductions to base pay rates are rare and generally only happen under extreme circumstances. This employee perception of entitlement to maintaining current levels is due to past patterns. 

A 45-year analysis of the relationship between inflation and pay levels shows that pay has increased at a greater rate than inflation… an aggregated average of about 1% per year.  In some years inflation outpaced pay increases (1974, 1976, 1979, 1980 & 1981), but in all other years pay growth has exceeded inflation by varying amounts.  The realities associated with the pay – inflation relationship are the reasons it is so important that employers manage their pay systems based on cost of labor, rather than trying to respond to inflation. Employees would prefer the higher of the two numbers being used each year to adjust pay levels, but based on historical patterns this is economically unsustainable due to compounding of cost levels. 

The last two years have been so unstable due to the pandemic determining what has happened to competitive pay levels is difficult. Traditionally survey data is available annually that informs employers as to what has happened in the competitive labor markets – i.e., what their competitors for talent have done. Although surveys are not altogether useless in 2021 the data should be suspect because so many workers have been laid off or furloughed, and because governmental subsidies to those unemployed have been so large (e.g., $ 600 per week) that some may have delayed returning to work since they are better off economically when not working.  Aggregated measures of pay increases reported in surveys may be statistical artifacts, which makes them less valuable. The most troubled organizations will be likely to have dropped out of surveys in large numbers. Additionally, the rates of lower paid workers will be missing in larger numbers, since they are most often the people who have moved out of work. When the lowest values drop out of a sample at a greater rate than the high ones the average change from one year to the next is artificially inflated.

Pay Management Strategies For Today

The chaotic economy has made it even more important for employers to formulate a philosophy and associated strategy for managing pay, both currently and into the future. The strategy must also be clearly communicated to, and understood by employees. One of the first steps is to articulate clearly what pay is based on. Three factors should determine what an individual employee is paid: 

  1. The value (internal and external) of the role played, 
  2. The competence in that role, and 
  3. The contribution (performance) in that role.  

It should also be made clear that individual characteristics (what someone looks like, what they believe and where they came from) should not impact pay. If employees are not told how the firm manages pay they will guess and that usually results in an unfavorable assessment. This simple message cannot be communicated too often.

The value of the role played is based on both an assessment of the relative internal value to the organization and the value it commands in the external labor market. Many organizations contend their pay levels are “internally equitable and externally competitive.” Relative internal values are typically established using some type of job evaluation method and are based on the nature of the individual employer.  A software programmer may be more valuable to a software firm than to a hospital on a relative basis, since that role is more central to the primary mission and more critical to the performance of the software firm than it is to the hospital. 

External value is determined by the relationship between the supply of and demand for skills in the relevant labor market.  Software programmers may command higher pay based on market levels than what the relative internal value of the job is to the hospital creating a dilemma. Each employer must reconcile internal and external value in some manner but cannot be indifferent to either. A highly qualified Nurse in a hospital may be offended by a software programmer being paid more, even though the organization is responding to conditions in the relevant labor market. But in order to get and keep software skills this may be necessary. 

Responding to competitive market rates when competitive data is suspect puts employers in a difficult position. If pay rates are low relative to levels actually prevailing in the labor market critical skills may be lost. If the reality is discovered too late to make adjustments the talent may already have gone. Yet paying more than is necessary will impact costs. Trial and error is not an effective approach to testing an employer’s competitive position. But the current realities heighten the risk of being non-competitive and paying  the price.  For those organizations whose revenues have been negatively impacted by current economic conditions raising pay levels may not be feasible, even if it is believed that it is necessary to make good on the claim that the organization pays competitively.

There is no magic fix to this dilemma. The best strategy is to convince employees that the organization is making a good faith effort to pay competitively and assure them that adjustments will be made when economic conditions allow it.  Every attempt should be made to consider other ways to enhance the value proposition the organization provides to its employees. There may be non-monetary things that can be done to show employees they are valued.  Being flexible about work location and scheduling when it is feasible may be valued. More open and more continuous communication about conditions can help employees understand the realities being faced by their employers. Changing employers has costs and reminding employees that someone’s claim that the grass is greener over there might not be altogether true.