Corporate America Is Facing a Compensation Conundrum

Kiran

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

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

However, with inflation as high as that, the wage freeze is basically an 8% pay cut. That’s enough to create cash flow problems for many households, especially those who cannot afford debt with consumer credit levels also rising rapidly. Or can’t grind through by putting in extra time at work because flexible worker 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 employees, the fewer options all households have for cash-flow shortages and core employees are more vulnerable to inflation eroding their earnings.

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On the other side of the blade, employers may be acutely aware that hefty raises are needed so that their core employees can keep up with the rising cost of daily necessities such as food and energy. To accomplish this, employers can isolate workers who fall outside the core group. Doing so allows businesses to protect those who are most likely to stay with them when the situation begins to escalate. The problem, though, is that protecting the core workers against the ravages of inflation raises the cost per worker for the business, and that itself contributes to inflation. This scenario leads to the dreaded unmooring of inflation expectations that the Federal Reserve fears above all else. This means that even if inflation slows down a little, it requires a large increase in unemployment because those workers who are still employed retain their purchasing power.

Taken together, the two blades imply that the Fed’s efforts to lower inflation expectations by rapidly increasing interest rates will either lead to a sharp and contagious rise in financial instability for working class households or an unmooring of inflation expectations caused by business. In either case, the hit to working class households may be much harder than just about who is estimated because the high level of inflation now creates an offsetting threat that we have not seen at least since the mid-1970s, when the last economy adjusts to. structurally high inflation. Back then, about half of the baby boomer generation were full-time working adults. The younger half of that generation and the next did not experience the challenge of adjusting to sudden, unpredictable and persistent inflation.

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There is no obvious way to solve the dynamic two-sided problem. As the problem becomes worse, the risk of being too slow in solving them grows. Alternatively, the potential for side effects associated with rapid problem solving increases. It is difficult to anticipate where and how those effects will balance. The Fed has opted for a fast track of aggressive rate hikes, confident that there will be no repeat of the financial instability that followed former Chairman Alan Greenspan’s aggressive rate hikes between 2004 and 2006 thanks to new rules and regulations that make banking easier. more secure system.

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I support the Fed’s current path, and I have no doubt that the new safeguards have made the financial system more stable. Nevertheless, I would not be surprised if policymakers find themselves with some financial instability that no one has considered, because it is a novel threat created by this new inflationary environment that is most vulnerable to amplification and contagion if the Fed tries to quickly bring inflation. return to the target.

More from Bloomberg Opinion:

• The Global Central Bank may have arrived: Daniel Moss

• Fed gives Americans a lesson in Lag Time: Alison Schrager

• The Fed is underplaying the Pain of Fighting Inflation: Bill Dudley

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Karl W. Smith is a Bloomberg Opinion columnist. Previously, he was vice president for federal policy at the Tax Foundation and an assistant professor of economics at the University of North Carolina.

More stories like this are available at bloomberg.com/opinion

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