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How big a raise you should give your employees with inflation at a 40-year high

April 13, 2022, 12:58 PM UTC

From gas to food, the cost of everyday items has soared over the last year, squeezing Americans’ pocketbooks and erasing much of their gains in pay raises.

As U.S. inflation surges to new heights, employers are increasingly debating whether to boost wages, as workers, who have more leverage in salary negotiations thanks to a long-running labor shortage, struggle to keep pace with the rising cost of living. 

“I’ve had more discussions about this in the last three months than in 20 years,” says Alan Johnson, whose New York City consulting firm Johnson Associates advises major companies on pay. 

Consumer prices rose to a 40-year high of 8.5% in March, according to federal data released Tuesday, and it’s hitting Americans’ wallets hard. But determining whether to hike pay is multipronged, sometimes counterintuitive, and complicated by its own pandemic twist. It’s especially vexing for today’s corporate leaders, few of whom were running a business in 1982, the last time inflation was this high. Their concerns center on a few basic queries:

Do I have to adjust wages for inflation to be competitive in the labor market?

Generally speaking, no. Compensation—encompassing salary, paid time off, sick leave, parental leave, and other benefits—is often determined by the labor market, which, like all markets, reflects supply and demand. It doesn’t directly reflect inflation, nor does it need to. Think of it this way: For most of the past decade, U.S. companies have budgeted annual salary increases of about 3% on average. Inflation rates have been well below 3% for most of that time, yet “there was no talk about lowering salary budgets to meet them,” says Lori Wisper, a compensation consultant at Willis Towers Watson in Chicago. Similarly, pay doesn’t necessarily have to rise just because inflation goes up—but many large employers do plan to raise salaries this year.

Is it really that simple?

Of course not, but it’s worth remembering the bedrock principle that compensation is inextricably linked to the supply of and demand for workers. For that reason, the main question to answer is how inflation might affect supply and demand. It could happen in various ways:

Inflation could prompt those who took part in the Great Resignation to return to work. After all, labor force participation, which plunged in the pandemic’s early days, has made only a halfway comeback. Analysts predict the remaining half will eventually return to work, but higher inflation could incentivize them to act sooner. Ironically, an inflation-induced increase in labor supply would put downward pressure on pay.

In the same way, high inflation may frighten retirees, or those planning to retire, whose nest eggs look alarmingly inadequate at 7.5% inflation versus the 2% inflation of years past. “If you’re hearing medical bills are going up, rent’s going up, food’s going up, you look at your significant other and say, ‘Is this really the time we want to walk away from our jobs?’” Johnson says. If workers who would otherwise leave the job market stay, the effect will again be downward pressure on pay.

In theory, inflation prompts workers to demand higher wages, effectively reducing labor supply at current wage rates. But in practice, prospective employees compete with one another for jobs, making it difficult for individuals to make higher pay demands stick. For example, a job candidate who determines that keeping up with inflation requires an hourly wage of $40 might be undercut by others willing to accept $39 rather than be jobless. Union members are another matter, since most have cost-of-living increases in their contracts. But only about 10% of U.S. wage and salary workers belonged to unions last year, per the Bureau of Labor Statistics, a percentage that has been on the decline for decades. 

The pandemic changed work dramatically. Doesn’t that mean traditional rules of pay also need to change?

Yes. In fact, the shift to remote work offers a preview of how employers are adjusting pay to reflect cost of living. Facebook (now Meta Platforms) and Google announced plans in 2020 to let some employees work remotely, with pay partly based on geography. “We’ll adjust salary to your location,” Facebook CEO Mark Zuckerberg told employees in May 2020, adding that there would be “severe ramifications for people who are not honest about this.”

The model has not caught on across industries. Pre-pandemic, most employers paid workers in different locations varying salaries not because of living costs, but because labor markets were presumed to be local or regional. Since the explosion of remote work, major employers have come to realize that for some jobs, such as software engineering, the labor market is national or even global. “Companies will start using more national-average-type pay rates versus geographically driven pay rates for some jobs,” Wisper says.

Explicitly tying pay to inflation would be painfully troublesome in any case. The current inflation rate is a national average of widely divergent localities: 9.6% in the Tampa–St. Petersburg–Clearwater area and 5.1% in the New York City–Newark–Jersey City area. Yet living costs are far higher in the latter area. Imagine the response when employees in New York find out Tampa-based colleagues are getting a raise that almost doubles theirs.  

Can a company become an employer of choice by promising to keep wages inflation-adjusted?

While tempting, some say the decision may not be wise. Employers should pledge to offer salaries that are competitive in relation to the marketplace and employees’ skills. But they should refrain from promising to keep wages inflation-adjusted, Johnson says. “Sooner or later inflation will spike, the economy will tank, and then you can’t afford it. Now you’ve lied to people.”

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