Corporate America Is Facing a Compensation Conundrum

The highest rates of inflation in 40 years and the response by central banks around the world to aggressively raise interest rates have created an unfamiliar double-edged sword for both businesses and households.

On one side of the blade you have employers with little experience taking inflation into account when determining compensation. With interest rates rising so fast and a recession in the cards, it might seem like common sense to freeze wages and cut overtime and part-time hours. Such a strategy would protect so-called core employees, or those who are full-time workers that have been with the company for an extended period and are least likely to quit in the near future.

However, with inflation as high as it is, freezing wages essentially amounts to an 8% pay cut. That’s enough to create cash-flow problems for many households, especially those that can’t afford to take on debt with rates on consumer credit also rising fast. Nor can they grind through by putting in extra time at work because flexible employee hours are being reduced. Worse, there is an amplifier effect. The more companies turn to strategies like freezing wages and reducing overtime to protect core workers, the fewer options all households have for dealing with a cash-flow shortage and the more vulnerable core employees are to inflation eroding their earnings.

On the other side of the blade, employers may be acutely aware that hefty raises are required so their core workers can keep up with the rising cost of everyday necessities such as food and energy. To accomplish this, employers might lay-off workers who fall outside the core group. Doing so allows businesses to better protect the people most likely to still be with them when conditions might start to improve. The problem, though, is that protecting core workers against the ravages of inflation raises the cost per worker for businesses, and that itself contributes to inflation. This scenario leads to the dreaded unmooring of inflation expectations that the Federal Reserve fears above all else. It means that even getting inflation to slow just a little requires large increases in unemployment because those workers who are still employed retain their purchasing power.