Impact of Inflation on Employee Compensation

Inflation is the surge in the prices of goods and services over a given period. Until recently, no one was talking about inflation since the annual inflation rate in most countries averaged below 2%, which is considered healthy for an economy.

But now, inflation is a global discussion. This is because the annual inflation rates have soared to an all-time high in many countries, reducing the population’s purchasing power and increasing the cost of living. 

While the rapid increase in the price of goods and services is challenging for various reasons, it poses a big question for employers– as inflation rates soar worldwide, how will it affect employee salaries and wages?

How companies decide to respond to this question will significantly impact employee retention in the current tight labour market where many employees are on the move in search of better pay. 

Types of Inflation 

The following are the types of inflation that exist in an economy:

1. Demand-pull inflation

‍The economy’s aggregate demand for goods and services surpasses the aggregate supply.

2. Cost-push inflation

‍The aggregate supply falls due to an increase in the cost of factors of production. 

3. Hyperinflation

‍The prices of commodities increase by over 1000%, and the value of money declines.

4. Stagflation

‍High inflation, high unemployment, and stagnant demand for goods and services in an economy. 

5. Deflation/Negative inflation

‍The general fall in the price of goods and services in an economy due to various reasons. 

How Does Inflation Affect Wages, Salaries, and Prices? 

As the inflation rate increases in a country, the prices of common goods and services automatically rise. In return, it reduces the consumers’ overall purchasing power. 

For instance, two years ago, a monthly salary of $4,000 and monthly expenses of $2,000 reflected a 50% spending of the salary on monthly costs.

Fast-forward to 2022, the monthly salary is the same, but the prices of goods are at a record high. This means that more than 50% of the monthly salary will be spent on the same expenses, affecting the amount saved every month. 

Such events erode the actual value of an employee’s salary. Therefore, employees’ expectations regarding their compensation start changing. Employees are forced to demand better compensation packages from their employers for their purchasing power to keep up with the current inflation rates. 

As inflation increases, employee salaries and wages increase. The increase in salaries and wages is never at pace with the prevailing inflation rates as it would create a wage-price spiral that could easily ruin the economy.

This is because the increase in wages and salaries will drive up the production costs, which the companies will have to pass on to the consumers through higher prices to break even. 

As a result, most companies raise salaries and wages only to the extent that the value of employees' production increases. Employers will only increase salaries and wages to a level that attracts top talent in the labour market and makes them competitive per the current economic climate.

This is done either because the employees are producing more goods than before or because the prevailing inflation rates increase demand for certain goods and services. 

Another reason the increase of wages and salaries is never at pace with inflation is that wages and salaries are sticky. Most of the time, employers do not reduce wages and salaries unless it is for serious structural issues.

Therefore, since wages and salaries are difficult to reduce, most companies are not quick to raise them before determining how the increase will affect the business in the long run. For instance, when the pandemic began and labour shortages increased in most countries, employers did not necessarily lower salaries and wages. 

Ways to Compensate Employees in the Face of Inflation

1. Develop a hybrid work model to make your employees more flexible and happier.

2. Offer free meals and beverages. 

3. Offer education and training programs.

4. Give them bonuses based on their performance and the company’s sales volume. 

5. Avoid increasing healthcare premiums. 

6. Offer employee benefits that cushion them during high inflation periods.

7. Invest in valuable perks such as groceries and transport incentives. 

How Does Inflation Affect Employment? 

As inflation rates soar, most companies are forced to increase their salary and wage budgets to retain the services of their employees.

Even though increasing salaries and wages during inflation will make employees happier, it can seriously impact a company’s bottom line. It explains why many companies raise wages and salaries to retain their employees. 

Alternatively, companies that fail to increase wage and salary budgets to match the prevailing inflation rates face increased employee turnover.

This is because employees quickly quit their jobs in search of higher pay in a highly competitive labour market. If employees do not feel like their companies are paying them enough to cope with the rising inflation, they are likely to leave. 

Therefore, companies must make better job offers to attract potential employees and remain competitive in the job market. When inflation increases, the rate of employment increases since employers spend more on hiring.

However, this only happens temporarily. Once the new prices adjust to the wage increase, the economic output and employment levels will return to their natural state.

How Does Inflation Impact HR?

Even with the high inflation, not all companies will or can increase their employee salaries and wages. This means that the HR professionals need to be more involved in the pay discussions to help minimize employee turnover in their companies. HR leaders need to be ready to address employee concerns clearly and regularly. 

Some of the things HR departments will need to do in the face of inflation include:

1. Prepare the managers to communicate clearly with the employees regarding their pay and high inflation.

2. Avoid passing the company’s increased running costs to the employees.

3. Provide bonuses to employees based on individual and company performance. 

4. Advise the company’s management to invest in employee education, training, and mentorship programs. This way, the employees gain knowledge, skills, and experience. This also shows the company's willingness to invest in its workers even during challenging economic times. 

5. Adopt a hybrid workplace model so that employees can enjoy more flexibility.

How Does Inflation Affect Shareholder Value? 

Many people do not believe that inflation affects a company’s value. After all, if the prices of raw materials and operational costs increase, the companies can pass them to their clients by raising prices, thus preventing inflation from lowering shareholder value.

Additionally, some managers assume they can maintain or increase shareholder value by ensuring that the company’s earnings remain at pace with the prevailing inflation rate. 

However, this is not the case. For a company to prevent high inflation from eroding shareholder value, it must ensure that the earnings grow faster than the inflation rate. This is something that most companies struggle with. 

For instance, if the inflation rate stands at 10% and a company wants to maintain or increase the shareholder value, it must ensure that its earnings grow by approximately 20%. The overall shareholder value will drop if they do not attain this target. 

Additionally, inflation makes it difficult for companies to maintain shareholder value because, to do so, they must pass on the increased operational costs to customers without lowering the sales volumes. If this does not happen, the company’s cash flows will reduce, and the shareholder value will diminish. 

In Conclusion

If employers can show their employees that they understand and relate to their financial concerns during high inflation and address them, they may convince them to stay.

However, employers need to develop a communication and compensation model that helps their employees understand they are part of the company's success and that employers care about their employees’ financial well-being.