How Inflation Affects Employee Compensation

September 12, 2023
November 7, 2023
Lyssa Test and Deanna deBara
Lattice Team

If you’ve been looking at your gas or grocery bill and thinking, “Well, this seems higher than usual,” you’re not imagining things. The United States is currently experiencing a period of inflation — and the rising prices that go along with it.

Inflation is challenging for a variety of reasons. But for employers, it poses a serious question: As inflation continues, what impact does it have on employee wages?

Below, we’ll take a closer look at how inflation impacts wages, what you need to keep in mind when adjusting compensation for inflation, and why it’s important to take the rising cost of living into consideration and make changes to your pay plan accordingly.

What Is Inflation — and How Is It Affecting Today’s Economy?

While it can seem like a complicated economic concept, “inflation is simply the sustained increase of prices throughout the economy,” explained Timothy F. Kearney, PhD, economist, market strategist, and Assistant Professor of Business at Centenary University in Hackettstown, NJ.

More specifically, the International Monetary Fund (IMF), a global organization focused on promoting sustained economic growth and reducing worldwide poverty, defines inflation as:

Inflation is the rate of increase in prices over a given period of time. Inflation is typically a broad measure, such as the overall increase in prices or the increase in the cost of living in a country. But it can also be more narrowly calculated — for certain goods, such as food, or for services, such as a haircut, for example. Whatever the context, inflation represents how much more expensive the relevant set of goods and/or services has become over a certain period, most commonly a year.

A certain amount of inflation is part of a normal economy. “Inflation under 2.0% annually is generally healthy for the economy as it shows growth,” said Kyle Asman, Managing Partner of Orlando-based private investment fund Backswing Ventures.

It’s when inflation starts to cross over the 2% threshold that things can get challenging. “Over 2.0%, it becomes a drag on the economy as prices increase too rapidly for consumers to absorb,” Asman said.

At this rate, we’re well past that threshold. “Currently, consumer price inflation is 5.4%,” said Kearney. And high inflation rates are expected to last through the rest of the year; the United States Office of Management and Budget (OMB) recently changed its inflation outlook forecast for Q4 2021 — from 2.1% (the forecast in May) to 4.8%.

The current inflation is being driven by a variety of factors (including disruptions in supply chains and continued COVID-related challenges), but the impact is felt by businesses and consumers alike.

“With inflation, businesses lose profits if they cannot pass on their input prices to their customers,” said Kearney. “Longer term, inflation makes it difficult for firms to plan for the future.”

The good news is most experts expect this wave of inflation to be temporary, and that the economy will be in a much better position in the coming years (OMB forecasted that inflation will drop to 2.5% by Q4 2022 and 2.3% by 2023).

The Impact Inflation Has on Wages

Generally, you consider giving your employees a raise because of tenure or performance, but inflation can also play a role.

Inflation has a direct impact on the purchasing power of the dollar — which, in turn, has a direct impact on the value of your employees’ compensation packages. “When inflation rises, the purchasing power of compensation does fall,” Kearney noted.

And when you combine the declined value of the dollar with the labor shortages the US is currently experiencing (and the corresponding demand for workers), it’s clear that employees’ expectations around compensation are changing. According to data from the Federal Reserve Bank of New York, in March 2021, the mean annual salary job seekers expected from their job offers was $60,610 — up from $53,676 in March 2020, an increase of nearly 13%.

So if you want your organization to stay competitive and attract and retain top talent, it’s crucial to review your compensation plans — and make any adjustments necessary to ensure your employees are receiving wages that make sense for today’s economic climate.

Adjusting Compensation Plans to Keep Up With Inflation

How, when, and how much you adjust your compensation plans will depend on a variety of factors. For example, if your business employs hourly workers, you probably have a set schedule for wage increases (e.g. annually). But in the face of current inflation numbers, you may need to adjust their hourly rate sooner than you typically do.

“Most compensation increases are done on an annual basis,” Asman said. “But when you have 5-6% inflation, a consumer is going an entire year with 94-95% of the purchasing power [of] the prior year.”

Workers with a lower wage can also have a harder time navigating the financial challenges of inflation, which should be an added incentive to increase wages as soon as possible.

“The impact of inflation is significantly worse for hourly wage workers,” Asman pointed out. “Someone making $200,000 annually is a lot less likely to be affected by an extra $20 to fill up their car with gas — versus someone making $10 per hour who now needs to work an additional two hours to fill up.”

Increasing hourly wages will, of course, increase your labor costs, but generally, those increases are manageable. Wage increases for more highly compensated employees, on the other hand, can be a bit trickier. Increasing wages for employees with higher salaries locks you into that salary moving forward (even if inflation returns to a more manageable level), which, when extrapolated across the company, can put a major strain on your budget.

Plus, whether you’re dealing with hourly or salaried employees, constantly trying to adjust wages for inflation can be like chasing a moving target: “Increasing salary or hourly wages can’t always keep up with the pace of inflation,” said Asman.

That’s why many companies opt for another kind of wage increase. “More highly compensated employees often receive bonuses,” Kearney said. This type of compensation increase can be attractive because “firms can tweak pay without the risk of locking in raises into [future] years,” he noted.

How much you increase wages will also depend on a variety of factors. Some things to consider when adjusting your employee compensation strategy for inflation include:

  • Competitor Compensation: If you want to attract and retain top talent, you need to pay them a competitive wage. Doing competitive research (for example, using or Glassdoor’s Salary Index) can give you insights into how much your competitors are paying (and how much they’re increasing wages during this time of increased inflation), which can help you adjust your compensation plans accordingly.  
  • Budget: If you’re planning to increase employee compensation, you need to find that money somewhere, which means you need to look in your budget to determine how you are going to account for increased labor costs. Can you increase the price of your products or services? Are there areas where you can cut back spending to make room in your budget for increased wages? Examine this closely to see what makes the most sense for your organization and your employees.
  • Inflation Projections: As mentioned, the Office of Management and Budget expects inflation to return to more manageable levels in 2022, which could impact how and how much you increase employee compensation. For instance, if you feel confident that inflation will return to normal levels over the next few months, you may consider giving employee bonuses versus salary increases to tide over your staff until things stabilize. On the other hand, if you believe that inflation is here to stay through 2022 and beyond, increasing employee wages for the long term might feel like the better solution.

At the end of the day, inflation diminishes the value of the dollar. And in order to ensure that employees can stretch their dollars enough to cover their needs, it’s essential for organizations to rethink their approach to employee compensation and make any changes necessary to help their staff weather the challenges of the current inflated economy.

Employees need to be compensated fairly for the work they do for your company, and while at face value this is an added expenditure, it will ultimately benefit your organization, too. You don’t want your staff coming to work distracted by financial worries because their pay hasn’t kept pace with inflation. Pay your employees fairly — which includes adjusting for changes in response to the greater financial climate — and they can focus on their work and not be distracted by how to feed their families, afford their commute to the office, or manage other pressing financial stressors.