Corporate America Is Facing a Compensation Conundrum

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

On one side of the spectrum, you have employers with little experience adjusting compensation for inflation. With interest rates rising so fast and a recession looming, 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 employees who have been with the company for a long time and are likely to leave their jobs in the near future.

However, with inflation as high as it is, a wage freeze essentially means an 8% pay cut. That’s enough to cause cash flow problems for many households, especially those who can’t afford to take on debt, and consumer credit rates are also skyrocketing. They also can’t grind by putting in extra time because the flexible working hours of employees are reduced. Even worse is the amplifier effect. The more companies turn to strategies such as wage freezes and reduced overtime to protect key workers, the less all households have to deal with cash flow shortfalls and the more vulnerable key workers are to inflation, which erodes their incomes.

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On the other hand, employers may be fully aware of the need for high salaries to keep their key workers on top of the rising costs of daily necessities such as food and energy. To do this, employers can fire non-core employees. This allows companies to better protect people who are likely to still be with them when conditions might start to improve. The problem, however, is that protecting key workers from the ravages of inflation increases firms’ costs per worker, which itself fuels inflation. This scenario leads to the dreaded deflation of inflation expectations that the Federal Reserve fears most. This means that even a slight slowdown in inflation requires a large increase in unemployment, as workers who are still employed retain their purchasing power.

Taken together, these two elements mean that the Fed’s attempt to lower inflation expectations by sharply raising interest rates will lead to a sharp and contagious increase in financial instability for working-class households or a decline in inflation expectations caused by businesses. In both cases, working-class households may suffer much harder than almost anyone realizes, as the current high rate of inflation poses a countervailing threat the likes of which we have not seen since at least the mid-1970s, when the economy last adjusted. structurally high inflation. Back then, about half of the baby boomers were full-time working adults. The younger half of this generation and future generations have not experienced the challenge of adjusting to sudden, unexpected and prolonged inflation.

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There is no obvious way to solve dynamic reciprocal problems. As problems escalate, the risk that they will be resolved too slowly increases. Alternatively, the potential side effects associated with problem solving add up quickly. It is difficult to predict where and how these effects will balance out. The Fed has chosen a fast path 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 have made banking. the system is more secure.

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I support the Fed’s current path and have no doubt that these new safeguards have made the financial system more stable. However, I wouldn’t be surprised if policymakers face some financial instability that no one has considered, since it is the new threats that this new inflationary environment poses that are most susceptible to amplification and contagion if the Fed tries to get inflation up to speed. back to the target.

More from Bloomberg’s opinion:

• The World Central Bank May Have Arrived: Daniel Moss

• The Fed is teaching Americans a lesson during the delay: Alison Schrager

• Fed underplays inflation-fighting pain: Bill Dudley

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

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

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