Corporate America faces a compensation conundrum

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

On one side of the blade, you have employers who have little experience with taking inflation into account when determining compensation. With interest rates rising so rapidly and a recession looming, it might seem logical to freeze wages and cut overtime and part-time hours. Such a strategy would protect so-called entry-level employees, or those who are full-time workers who have been with the company for a long time and who are least likely to quit in the near future.

However, with inflation as high as it is, the wage freeze essentially amounts to an 8% pay cut. This is enough to create cash flow problems for many households, especially those who cannot afford to take on debt, with consumer credit rates also rising rapidly. They also can’t get away with spending more time at work because employees’ flexible hours are reduced. Worse, there is an amplifying effect. The more companies turn to strategies such as wage freezes and overtime cuts to protect rank-and-file workers, the fewer options all households have to deal with a cash shortage and the more rank-and-file workers are vulnerable to inflation which erodes their income.

On the other side of the slide, employers may be acutely aware that steep increases are needed for their key employees to meet the rising cost of daily necessities such as food and energy. To do this, employers could lay off workers who are not part of the core group. This allows companies to better protect the people most likely to still be with them when conditions might start to improve. The problem, however, is that protecting core workers from the ravages of inflation increases the cost per worker for businesses, which itself contributes to inflation. This scenario leads to the dreaded undocking of inflation expectations that the Federal Reserve dreads above all else. This means that even to moderate inflation slightly requires large increases in unemployment, because workers who are still employed retain their purchasing power.

Taken together, the two slides imply that the Fed’s attempt to lower inflation expectations by rapidly raising interest rates will either lead to a sharp and contagious increase in financial instability for working-class households, or to a drop in inflation expectations caused by companies. Either way, the blow to working-class households may be much harder than anyone realizes, as the current high level of inflation creates offsetting threats we haven’t seen at least since the mid-1970s, when the economy was last adjusting to structurally high inflation. Back then, about half of baby boomers were full-time employed adults. The younger half of this generation and those that followed did not have to face the challenge of adapting to sudden, unexpected and persistent inflation.

There is no obvious way to solve double-edged dynamic problems. As problems get worse, the chances of being too slow to solve them increase. Alternatively, the potential side effects associated with fixing the issues increase rapidly. It is difficult to predict where and how these effects will balance out. The Fed has opted for the fast track of aggressive rate hikes, confident that the financial instability that followed former Chairman Alan Greenspan’s aggressive rate hikes between 2004 and 2006 will not be repeated thanks to new rules and regulations that will have made the banking system safer.

I support the current course of the Fed, and I am convinced that these new guarantees have made the financial system more stable. Nonetheless, I wouldn’t be surprised if policymakers end up with some financial instability that no one has considered, because it is precisely the new threats created by this new inflationary environment that are most susceptible to amplification and contagion if the Fed is quickly trying to bring inflation back towards its target.

More from Bloomberg Opinion:

• The World Central Bank may have arrived: Daniel Moss

• The Fed teaches Americans a lesson on jet lag: Alison Schrager

• The Fed plays down the pain of fighting inflation: Bill Dudley

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

Karl W. Smith is a Bloomberg Opinion columnist. Previously, he was Vice President of Federal Policy at the Tax Foundation and Adjunct Professor of Economics at the University of North Carolina.

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

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